Some  Aspects  of  Banking 

Theory 


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Some  Aspects  of  Banking 

Theory 


BY 

WILLIAM  HOWARD  STEINER,  B.  S.,  A.  M. 

Assistant  Director,  Division  of  Analysis  and  Research, 
Federal  Reserve  Board 


NEW   YORK 

W.  D.  Gray,  106  Seventh  Ave. 
1920 


Copyright,  1920 

BY 

William  Howard  Steiner 


I 


■ 


TO 

F.  T.  S. 


M 


* 


-K. 


57 


PREFACE 

In  the  study  which  follows,  an  attempt  has  been  made  to 
select  for  detailed  analysis  certain  aspects  of  the  institution 
of  banking  which  it  is  believed  are  of  fundamental  impor- 
tance for  an  understanding  of  the  role  which  banking  plays 
in  modern  economic  society.  The  aim  has  not  only  deter- 
mined the  general  character  of  the  topics  discussed,  but  has 
also  set  definite  limits  to  the  scope  of  the  study  and  to  the 
problems  which  are  considered.  The  operation  of  the  bank- 
ing system  as  a  whole  is  of  interest,  rather  than  the  question 
of  its  technical  organization,  while  for  the  purpose  at  hand 
the  reserve  problem  is  of  little  consequence,  and  neither  it 
nor  the  influence  which  the  banking  system  may  exert  upon 
general  prices  has  been  discussed  at  length.  The  aim  has 
likewise  influenced  the  method  of  treatment.  The  analysis 
proceeds  almost  entirely  upon  the  real  as  distinguished  from 
the  pecuniary  level,  and  the  psychology  of  credit  has  not  been 
considered.  At  the  same  time,  however,  due  attention  has 
been  given  to  the  evolutionary  character  of  the  modern  in- 
stitution of  banking,  and  the  assistance  obtained  therefrom  in 
arriving  at  a  better  understanding  of  the  institution  itself. 
Inasmuch  as  the  purpose  has  been  primarily  constructive 
rather  than  critical,  mention  has  been  made  of  other  writers 
only  incidentally,  in  connection  with  the  discussion  of  specific 
problems.    No  attempt  has  been  made  to  indicate  those  who 


8  PREFACE 

originally  formulated  the  various  doctrines  mentioned,  and 
there  is  given  merely  the  statement  which  is  believed  to  be 

best  suited  to  the  purposes  of  the  particular  discussion. 

The  writer  is  indebted  to  Mr.  H.  Parker  Willis,  Professor 

of  Banking  in  Columbia  University,  for  reading  tentative 

drafts  of  several  parts  at  an  early  stage  of  the  work,  as  well 

as  for  reading  the  completed  manuscript,  and  making  many 

helpful    suggestions.      Acknowledgment    is    also    due    Dr. 

H.  R.  Seager,  Professor  of  Political  Economy  in  the  same 

institution,  for  reading  the  first  six  chapters,  and  making 

suggestions  on  certain  points. 


37  Liberty  Street,  New  York, 
August  1,  1920 


CONTENTS 

CHAPTER  I 

THE  EVOLUTION   OF  HANKING 

PAGE 

1.  The  institution  of  banking 11 

2.  The  Middle  Ages   15 

3.  Banking  and  the  currency  system 21 

Note  and  deposit  currency  24 

4.  Rise  of  commercial  banking    26 

5.  Rise  of  investment  banking 32 

CHAPTER  II 

BANKING   IN   THE   PRESENT   ECONOMIC   ORDER 

1.  The  definition   of  banking 34 

2.  Banking  as  commerce  in  capital 38 

3.  The  economic  process 40 

4.  Temporary  and  permanent  capital  requirements 43 

Commercial  banking  and  investment  banking 45 

5.  The  Pool  of  commercial  financing  and  the  pool  of  invest- 

ment financing 46 

CHAPTER  III 

COMMERCIAL  BANKING 

1.  The  pool  of  commercial  financing  49 

2.  Lower  level  of  the  analysis 53 

Coalescence  of  capital  supply  and  the  currency  system..  54 

3.  Commercial  banking  as  center  of  the  commercial  credit 

system    55 

4.  Analysis  of  constituent  funds  on  the  lower  level 58 

5.  Relation  between  the  two  levels 60 

Extension  and  cancellation  of  commercial  banking  credit.  61 

6.  Veblen's  doctrine  of  the  loan  fund 65 


CHAPTER  IV 

SOME   FURTHER   ASPECTS   OF   COMMERCIAL   BANKING 

1.  Guaranty  function  of  commercial  banking 68 

Anticipation  of  the  future 70 

2.  The  collateral  loan    72 

3.  The  line  of  credit 77 

CHAPTER  V 

SOME   FURTHER   ASPECTS    OF   COMMERCIAL   BANKING    {Coflt.) 

1.  The  extractive  stage  in  the  economic  process:  agriculture  82 

2.  Relation  of  commercial  banking  to  an  enterprise  embrac- 

ing several  stages  87 

3.  The  final  stage:  consumption  good 89 

Capital    good    92 

4.  Financing    of    futures 94 

5.  Theory   of   commodity   speculation 96 

6.  Volume  of  speculation 101 

7.  Summary     103 

CHAPTER  VI 

INVESTMENT  BANKING 

1.  The  pool  of  investment  financing 107 

2.  Service  of  security  speculation 112 

3.  Investment  banking   types 116 

Extension  of  investment  operations 121 

5.  Commercial  loan  versus  call  loan 126 

6.  The  theory  of  banking 132 

CHAPTER  VII 

OPERATION    OF  THE   BANKING  SYSTEM 

1.  Banking  as  center  of  the  credit  system 135 

2.  Control  in  the  pool  of  commercial  financing  and  in  the 

pool  of  investment  financing 136 

3.  Inter-system    control 143 

4.  Price    effects    150 

War  finance  153 

5.  Banking  and  the  business  cycle 155 


CHAPTER  I 


THE    EVOLUTION    OF    BANKING 


1.  The  general  economic  conditions  of  the  age  mold  the 
special  economic  institutions  which  exist  The  institution 
of  banking  is  no  exception  to  this  precept.  Thus  it  is  neces- 
sary to  trace  what  for  us  are  the  later  stages  in  economic 
evolution  in  order  to  understand  the  evolution  of  banking. 
For  evolution  it  is ;  there  is  an  organic  process,  not  a  mere 
series  of  disconnected  events.  Just  as  the  life  of  an  indi- 
vidual may  be  conceived  of  as  a  process  of  progressive  self- 
realization,  so  also  does  the  life  history  of  an  institution 
reveal  a  progressive  unfolding ;  the  process,  apparently  hap- 
hazard, its  course  often  at  present  not  discernable,  is  yet 
purposive.  There  are  ends  towards  which  the  stream  is 
flowing,  although  when  the  ends  appear  in  a  measure  to  be 
attained,  perhaps  even  before,  the  ends  themselves  appear  to 
fade,  and  a  new  goal,  the  child  of  the  new  conditions,  peers 
above  the  horizon.  Such  is  the  story  of  the  development 
of  banking. 

Banking  represents  basically  a  specialized  technique  in 
the  supply  of  capital.  In  the  struggle  with  nature,  man  has 
found  it  necessary  to  arm  himself  with  certain  technical 
equipment,  which  grows  more  and  more  elaborate  with  the 
passage  of  time.  With  the  increase  in  the  complexity  of 
the  equipment,  the  task  of  obtaining  it  assumes  larger  pro- 
portions. The  individual  must  cease  to  rely  solely  upon  his 
own  efforts  and  his  own  resources;  instead,  a  cooperative 


12  BANKING   THEORY 

feature  is  introduced.    Waiving  discussion  of  possible  hypo- 
thetical situations  in  a  primitive  economy,  the  development 
of  this  upon  any  considerable  scale  implies  the  use  of  what 
we  generically  term  "money,"  as  well  as  the  institution  of 
certain  legal  relationships,  either  express  or  implied.    This 
cooperation  may  take  a  form  typified  either  by  the  loan  or 
by  the  partnership  or  company.    The  increase  in  the  scale  of 
enterprise,  with  its  need  of  increased  resources,  at  once 
creates  a  greater  demand  for  service  in  obtaining  funds,  and 
at  the  same  time  increases  the  difficulty  of  the  task.     In 
consequence,  specialization — a  universal  rule  of  economic 
life — develops.       A     specialized     institution — banking — is 
gradually  evolved.    The  purpose  for  which  the  intermediary 
is   created  may   conveniently  be   considered  as  two-fold: 
either  to  assemble  and  transmit  part  or  all  of  the  permanent 
capital  equipment   required  by  the  enterprise,   or  instead 
to  assemble  and  transmit  merely  part  or  all  of  the  circulat- 
ing capital  required,1  in  which  event  both  the  operation  to 
which  the  funds  are  applied  and  the  length  of  the  loan  are 
relatively  restricted.     Gradually  there  arises  recognition  of 
the  fact  that  cooperation  of  the  second  kind  may  be  effected 
among  the  business  community  as  a  whole,  which  then  acts 
both  as  recipient  and  as  source  of  supply  of  the  circulating 
capital  required,  rather  than  merely  as  recipient  of  capital 
supplied  by  a  distinct  class  of  investors.     With  economic 
advancement  comes  advance  in  the  methods  by  which  co- 
operation is  effected,  and  the  cooperation  becomes  more 
widespread,  at  the  same  time  that  it  becomes  more  sharply 
differentiated  from  cooperation  of  the  other  variety.     In 
short,  banking  itself  becomes  two-fold;  the  institution  of 

*The  permanent  capital  equipment  of  course  may  consist  of 
both  fixed  and  circulating  capital,  as  in  the  case  of  the  manu- 
facturing enterprise,  or  largely  of  circulating  capital  only,  as  in 
the  case  of  the  wholesale  house.    For  a  discussion  of  fixed  and 

circulating  capital,  cf.  Ch.  II,  Section  4. 


THE   EVOLUTION    OF   BANKING  13 

commercial  banking  must  be  clearly  distinguished  from  the 
institution  of  investment  banking. 

But  this  is  by  no  means  the  entire  story.    Banking  as  we 
know  it  today  is  a  blanket  term.     Moreover,  it  is  rather  a 
modern  conception.    Certain  of  the  technical  methods  have 
undergone  great  change,   while  new  ones  have  been  de- 
veloped.   True,  the  loan,  the  note  and  the  deposit  are  with 
us  yet,  but  the  resemblance  is  in  many  ways  more  apparent 
than  real.     In  their  modern  form  they  represent  rather  the 
result  of  the  progressive  adaptation  of  old  devices  to  the 
needs  of  the  modern  situation  as  it  has  developed.    In  as- 
signing to  the  term  banking  its  modern  connotation,  we 
may  say  that  under  earlier  conditions  banking  did  not — 
could  not — exist.    It  may  be  said  to  represent  the  historical 
time  coalescence  of  several  classes  of  business  which  have 
had  a  mutually  more  or  less  independent  historical  develop- 
ment.     To   employ   the    familiar    illustration,    commercial 
banking  involves  simultaneously  supplying  of  capital  and 
purveyance  of  currency.     Moreover,  the  institution  itself 
has  become  Janus-faced;  in  performing  the  one  service  it 
automatically  performs  the  other.    The  details  we  shall  see 
in  the  pages  which  follow.     Suffice  it  to  note  at  this  point 
that  the  Janus-faced  character  is  due  in  large  part  to  the 
fact  that  this  development  has  in  general  followed  the  line 
of  social   least  resistance.     With  the  rise  of  new  social 
wants,  it  is  often  found  that  the  simplest  method  of  satisfy- 
ing these  wants  is  thru  the  adaptation  of  an  existing  insti- 
tution, the  interests  of  which  are  somewhat  akin,  rather 
than  thru  the  creation  of  a  new  institution.    At  the  same 
time  that  the  process  of  integration  goes  on,  a  process  of 
differentiation  occurs.    There  is  a  sort  of  ceaseless  ebb  and 
flow;  various  strands  are  continually  joining  together,  and 
just  as  continually  otiiers  are  splitting  off.    Our  study  con- 
sists in  carving  out  a  period  in  time,  commencing  suffi- 
ciently prior  to  the  present  situation  to  enable  an  intelligent 


14  BANKING   THEORY 

understanding  of  the  conditions  now  existing.  We  con- 
sider how  the  various  strands  at  present  joined  together 
have  come  to  make  up  the  current  situation,  at  the  same 
time  that  we  take  cognizance  of  the  strands  which  have 
broken  away.  The  central  problem  is  to  attempt  to  visualize 
the  present  situation;  to  understand  what  the  institution  of 
banking  is,  and  what  it  is  doing.  But  this  involves  a  consid- 
eration of  how  it  came  to  assume  its  present  form;  only 
by  reference  to  its  historic  origins  can  it  be  understood. 
Hence  the  present  chapter. 

In  consequence,  too,  the  historic  problem  before  us  shifts. 
For  the  problem  in  hand,  the  conventional  discussion  of  the 
history  of  banking  affords  little  aid.  The  most  significant 
thing  is  by  no  means  the  etymologic  derivation  of  the  word 
"bank,"  whether  from  "bench"  or  from  "pile"  or  "heap." 
Nor  does  detailed  description  of  the  methods  employed  by 
the  Argentarii,  the  Fugger,  the  goldsmith  bankers  and  others 
suffice.  In  short,  the  problem  is  not  one  of  structure,  but 
one  of  function.2  Banking  then  will  concern  us,  rather 
than  the  bank.  Attempted  distinction  along  structural 
lines,  while  it  has  been  the  general  rule  in  the  treatment  of 
economic  phenomena  in  the  past,  due  perhaps  to  the  greater 
obviousness  of  structure  as  compared  with  function,  is  not 
only  arbitrary,  but  misleading  as  well.  Slight  reflection 
will  serve  to  show  that  the  accuracy  seemingly  obtained 
must  needs  be  specious.  That  human  relationships  and  the 
institutions  which  express  these  relationships,  are  complex, 
is  a  truism.  The  theory  of  multiple  correlation  must  be  ap- 
plied; linear  correlation  does  not  suffice.  Social,  and  more 
particularly  for  one  purpose,  economic  institutions  are  pro- 

2  The  functional  concept  is  well  illustrated  by  the  problem  of 
the  shares  in  distribution  as  contrasted  with  both  personal  dis- 
tribution and  the  ethical  appraisal  of  the  shares  often  attempted. 
Another  instance  is  afforded  by  J.  B.  Clark's  units  of  productive 
power  as  contrasted  with  the  actual  workers  themselves. 


THE   EVOLUTION    OF   BANKING  15 

ducts  of  evolution,  and  this,  as  just  indicated,  has  been 
along  the  line  of  social  least  resistance.  While  a  given 
structural  product  thus  has  a  basic  economic  function,  sub- 
sidiary activities,  which  later  may  attain  coordinate  rank, 
are  often  added,  the  outlines  are  blurred  as  a  result,  and 
soon  lost.  The  economies  of  large  scale  operation,  for  ex- 
ample, may  in  certain  cases  render  desirable  the  addition  of 
a  fiduciary  department  by  a  bank  doing  chiefly  a  commer- 
cial business,  and  vice  versa.  Or,  again,  the  performance 
of  the  basic  function  necessarily  implies  certain  methods  of 
performing  the  same,  some  of  which  may  be  employed  by 
other  classes  of  organizations  having  vitally  different  basic 
functions.  The  structural  cleavage,  in  other  words,  need 
not  correspond  to  the  functional. 

The  immediate  problems  before  us  are  two-fold:  in  the 
evolution,  how  have  the  functions  which  are  now  performed 
by  the  institution  of  banking  come  together,  and  how  have 
the  detailed  methods  of  performance,  that  is,  the  technique, 
involved  therein,  developed? 

2.  The  modern  institution  of  banking  has  its  roots  in 
the  Middle  Ages,  and  accordingly  there  our  study  must 
commence.  With  the  cycle  of  economic  life  which  had  its 
culmination  in  the  eternal  city  on  the  banks  of  the  Tiber 
we  need  not  detain  ourselves.  Likewise,  for  the  purpose 
at  hand  the  centuries  preceding  the  Crusades  may  well  be 
denominated  the  Dark  Ages,  though  perhaps  this  is  due  to 
our  lack  of  knowledge.  But  we  accept  the  heritage  which 
the  twelfth  century  had  from  its  predecessors,  and  at  that 
point  commence  our  contemplation  of  the  factors  in  the 
everchanging  situation  which  bear  a  more  direct  relation  to 
the  present  situation. 

The  attempt  has  often  been  made,  in  particular  by  the 
members  of  the  German  historical  school,  to  select  one  defi- 
nite criterion  by  means  of  which  to  distinguish  the  various 


16  BANKING   THEORY 

stages  in  the  process  of  economic  evolution.3  In  genera, 
differences  represented  are  primarily  in  the  angle  fro.n 
which  the  phenomenon  is  viewed.  Each  gives  a  partial  pic- 
ture. For  the  present  purpose  we  may  well  recognize  tie 
validity  of  the  contentions  of  the  partisans  of  each  of  tie 
divergent  criteria.  Banking,  as  we  have  seen,  presents 
many  phases,  and  in  its  development  is  related  more  closely 
now  to  this,  now  to  that  aspect  of  general  economic  de- 
velopment. In  short,  we  require,  not  a  choice  from  among, 
but  rather  a  synthesis  of,  existing  criteria.  We  must,  how- 
ever, select  from  the  multitude  of  facts  available,  and  have 
confined  ourselves  strictly  to  those  most  pertinent  to  the 
problem  at  hand. 

For  the  student  of  banking,  the  outstanding  feature  of 
the  earlier  Middle  Ages  is  the  lack  of  structural  differen- 
tiation between  capital  supply  and  commerce.  Only  later 
do  we  find  business  enterprises  whose  operations  may  be 

3  Among  more  recent  discussions  of  the  problem  may  be 
mentioned  that  in  the  opening  pages  of  Liefmann,  Beteiligungs-u. 
Financierungsgesellschaften,  Zweite  vermehrte  Auflage,  Jena, 
1913,  where  the  author  attempts  to  lay  the  theoretic  foundation 
for  his  later  study  of  financial  organizations.  In  contrast  to  his 
view,  which  regards  the  problem  as  one  of  changes  in  capital 
forms,  may  be  mentioned  that  of  Commons,  A  Documentary 
History  of  American  Industrial  Society,  Vol.  Ill,  Cleveland,  1910, 
Introduction,  where  the  influence  of  markets  upon  the  form  of 
economic  organization  is  stressed.  In  justice  to  the  authors 
mentioned,  it  must  be  stated,  however,  that  both  represent  rather 
an  attempt  to  select  a  criterion  believed  to  be  of  special  signifi- 
cance for  the  solution  of  the  particular  problem  at  hand,  and 
not  an  attempt  to  set  up  a  general  criterion  of  economic  evolu- 
tion. Mention  need  only  be  made,  among  older  discussions,  of 
the  controversy  raised  by  Bruno  Hildebrand's  attempt  in  his 
Natural-,  Geld-und  Creditwirtschaft,  Jahrbucher  fur  Nationalo- 
konomie  und  Statistik,  Zweiter  Band,  1864,  pp.  1-24,  to  find 
the  criterion  in  exchange,  and  thus  dividing  the  stages  into  nat- 
ural, monetary  and  credit  economy. 


THE   EVOLUTION    OF   BANKING  17 

termed  purely  financial.  Perhaps  the  best  known  illustra- 
tion of  the  transition  is  afforded  by  the  Italian  and  Upper 
German  merchants,  which  development,  Ehrenberg  tells  us, 
had  been  practically  completed  by  1640.4  The  same  phe- 
nomenon, however,  may  be  observed  time  and  time  again, 
principally  according  to  the  degree  of  economic  advance- 
ment, though  also  according  to  the  availability  of  the  exist- 
ing organization,  as  in  the  case  of  the  goldsmith  bankers  or 
the  London  acceptance  houses.  In  short,  in  point  of  time 
there  is  no  absolute  line  of  demarcation  possible;  each  na- 
tion, we  may  almost  say,  has  had  its  Middle  Ages.  As  Dun- 
bar has  pointed  out,5  a  distinct  hierarchy  move  across  the 
stage — the  Italians  (and  Germans),  the  later  Dutch,  and 
the  still  later  English,  each  economically  representing  the 
same  stage  of  development. 

Simultaneous  with  this  transition  is  the  general  develop- 
ment of  the  forerunners  of  various  of  the  technical  devices 
which  are  familiar  today.  Loan  and  deposit,  as  is  well 
known,  are  two  objective  sides  of  the  same  phenomenon. 
The  recognition  of  a  class  of  deposit  as  distinct  from  loan 
marks  an  advance,  in  that  it  represents  the  recognition  of  a 
distinct  organization  which  administers  these  deposits.  In 
the  early  Middle  Ages,  the  deposits  received  by  the  great 
mercantile  houses,  while  all  representing  savings,  originated 
from  several  sources — the  shares  of  retired  or  deceased 
partners  retained  in  the  business,  and  in  some  cases  funds 
obtained  from  relatives  and  friends  of  the  house,  both  bear- 
ing a  fixed  rate  of  interest,  also  sums  obtained  from  the 
clergy  and  larger  capitalists,  as  well  as  from  widows  and 
orphans.  These  deposits  were  used  in  the  ordinary  course 
of  the  business,  to  a  considerable  extent  in  trading  in  goods 


*  Das  Zeitalter  der  Fugger,  Jena,  1896,  Vol.  I,  p.  378. 

5  The  Bank  of  Venice,  Quarterly  Journal  of  Economics,  Vol. 


18  BANKING   THEORY 

of  various  descriptions  handled  by  the  particular  enterprise. 
In  other  words,  these  houses  themselves  obtained  from  other 
classes  by  means  of  the  deposit  principle  part  of  the  capital 
they  required.6  The  depositor  may  be  said  to  have  been  a 
species  of  bondholder  repayable  on  demand,  though  possess- 
ing no  special  security.  An  investment  operation  is  repre- 
sented. It  is  interesting  to  observe  that  this  device  was  also 
employed  in  public  finance  as  well  as  in  private.7  Consider- 
able risk  is,  however,  involved  in  the  procedure.  The  de- 
velopment was  essentially  empirical,  and  it  is  not  surprising 
to  find  that  the  method  of  trial  and  error  often  led  to  seri- 
ous difficulty. 

The  loans  which  were  made  in  addition  to  direct  employ- 
ment of  funds  in  ordinary  business  operations,  were  repre- 
sented largely  by  advances  to  Government.  From  one  point 
of  view,  such  loans  may  be  considered  merely  as  the  financ- 
ing of  one  particular  class  of  enterprise.  Although  of  over- 
shadowing importance  at  the  time,  this  early  relation  of 
banking  to  the  fiscal  needs  of  the  State  may  be  dismissed 
briefly.  What  is  now  recognized  as  an  evil,  necessary,  but 
nevertheless  an  evil,  was  then  regarded  as  highly  advan- 
tageous. As  the  potentate  has  given  way  to  the  modern 
State,  so  also  have  the  fiscal  needs  of  Government  become 
subordinated  to  the  general  social  welfare.  The  State  now 
ordinarily  takes  its  place  in  the  loan  market  upon  the  same 

VI,  1892,  pp.  308-335.  Reprinted  in  Economic  Essays,  New 
York,  1904,  pp.  143-167. 

6  Cf.,  e.  g.,  Dunbar,  Economic  Essays,  op.  cit.,  p.  149.  The  best 
evidence  .however,  is  afforded  by  a  study  of  the  balance  sheets 
presented  by  Ehrenberg,  op.  cit.,  in  his  description  of  the  oper- 
ations of  the  various  houses. 

7Cf.  Ehrenberg,  op.  cit.,  Vol.  II,  pp.  78,  274,  309,  for  instances 
of  employment,  both  actual  and  contemplated,  principally  by  the 
French  crown. 


THE   EVOLUTION    OF   BANKING  19 

basis  as  other  borrowers ;  except  in  times  of  great  immedi- 
ate need,  it  does  not  dominate  the  general  financial  situation. 
This  has  involved  the  disassociation  of  banking  and  public 
finance;  the  latter  represents  one  of  the  shoots  which  has 
split  off  as  increasing  specialization  has  developed. 

The  other  form  of  loan  is  typified  in  the  bill  of  exchange, 
and  in  a  two-fold  way.8  From  one  point  of  view  it  repre- 
sents a  raising  of  funds  by  the  process  of  the  finance  bill 
rather  than  through  the  deposit,  and  as  such  is  a  technical 
banking  device ;  from  the  other  point  of  view,  it  represents 
the  commercial  transaction.  By  both  these  means,  pooling 
of  the  circulating  capital  of  mercantile  enterprises  is  ef- 
fected; the  house  with  surplus  capital  at  the  moment  re- 
linquishes it  in  favor  of  the  house  which  finds  its  capital  in- 
sufficient for  its  present  needs.  But  direct  contact  between 
borrowing  and  lending  house  is  required.  Through  the  ab- 
sence of  an  institution  of  banking  structurally  distinct  from 
commercial  enterprise,  and  thus  holding  deposits  of  business 
enterprises,  there  is  not  effected  the  automatic  application 
of  the  surplus  of  one  business  enterprise  to  the  deficit  of 
another  which  characterizes  the  modern  situation.  The 
surplus  funds  of  another  business  enterprise  must  be  ob- 
tained either  through  purchase  from  it  on  time,  or  else 
through  the  sale  to  it  of  a  bill  of  exchange  or  other  obliga- 
tion. On  the  other  hand,  the  dovetailing  of  circulating 
capital  surpluses  and  deficits  of  business  enterprises  is  ren- 

8  The  actual  business  and  commercial  practice  of  the  Middle 
Ages  with  respect  to  these  matters  remains  in  considerable  ob- 
scurity, principally  because  the  problem  is  usually  never  raised. 
Possibly  Japanese  practice  prior  to  the  establishment  of  the  pres- 
ent dynasty  in  1868  might  afford  valuable  data  for  a  study  of  this 
kind,  and  be  illuminating  as  to  credit  customs,  etc.,  for  this  stage 
of  economic  development.  The  treatment  in  Goldschmidt,  Uni- 
versalgeschichte  des  Handelsrechts,  Stuttgart,  1891,  is  by  no 
means  entirely  satisfactory  for  our  present  purpose. 


20  BANKING   THEORY 

dered  more  difficult  under  an  economic  system  such  as  then 
prevailed.  In  the  absence  of  a  regular  economic  process  in 
which  goods  pass  through  a  series  of  stages,  yielding  peri- 
odically a  liquidating  counter  flow  of  funds  as  they  emerge 
from  one  stage  and  enter  the  next,  no  regular  automatic 
liquidation  of  loans  is  assured.  In  short,  there  is  no  pool 
of  commercial  financing  operated  in  the  manner  with  which 
we  are  at  present  familiar.9  The  difference  just  noted  in 
the  character  of  the  economic  process  is  typified  by  the 
economic  theory  developed  to  explain  the  existing  situation. 
Pre  Smithian  economics,  in  fact  based  upon  the  theory  of 
the  circulation  of  wealth,  sharply  differentiates  earlier  from 
present  conditions,  with  the  current  conception  of  the  pro- 
duction and  distribution  of  wealth.  Even  where  there  is 
structural  differentiation  between  capital  supply  and  com- 
merce, a  narrower  field  only  exists  within  which  coopera- 
tive application  of  circulating  capital  may  be  effected,  or  to 
which  the  capital  gathered  from  individual  investors  may  be 
applied.  That  the  doctrine  of  the  Church  concerning  usury 
was  due  to  the  use  of  loans  for  purposes  of  consumption 
has  become  a  commonplace,10  although  the  breaches  made 
in  the  doctrine  go  hand  in  hand  with  the  gradual  develop- 
ment of  commerce.  The  difference  in  the  conception  of  the 
economic  process  is  also  reflected  in  the  difference  in  the 
relative  importance  ascribable  to  industry  and  to  trade.  In 
the  period  considered,  the  handicraft  system  typified  in- 
dustry, while  trade  in  its  financial  ramifications  was  con- 
cerned in  large  measure  with  Grosshandel,  largely  specula- 
tive in  character,  and  the  foreign  trade.     Both  present  con- 

9  For  a  discussion  of  the  economic  conditions  which  are  influ- 
ential in  determining  the  character  of  commercial  banking,  cf. 
Section  4. 

10  The  doctrine  was  due  also  to  the  lack  of  a  theory  of  capital, 
confusion  existing  between  capital,  which  was  in  large  part 
circulating  rather  than  fixed,  and  money. 


THE   EVOLUTION    OF   BANKING  21 

siderable  difficulty  for  the  operation  of  the  institution  of 
banking. 

During  the  period  under  review,  the  relation  of  banking 
to  commerce  should  be  approached  rather  from  the  point 
of  view  of  the  system  of  commercial  payments.  This  sys- 
tem must  surmount  a  two-fold  difficulty,  that  of  distance, 
and  that  of  difference  in  currency  systems.  To  the  second 
is  due  the  rise  of  the  money  changers,  to  whom  Ehrenberg 
and  Knies  relate  banking  historically.11  Confined  at  first 
solely  to  the  business  of  the  house  itself,  later  payments 
were  effected  in  this  manner  also  for  others.  The  device 
then  has  become  a  means  of  economizing  in  the  use  of  the 
existing  monetary  supply.  In  due  time,  this  development 
was  carried  further  in  the  fairs  or  Messen  which  arose, 
with  their  technical  apparatus  for  the  cancellation  of  indebt- 
edness, and  thus  provided  an  approximation  to  the  modern 
clearing  system. 

3.  The  failure  often  attendant  upon  the  use  of  the  trial 
and  error  method  in  the  employment  of  deposits,  which  has 
been  remarked  above,  has  been  long  continued,  and  has  led 
to  the  employment  of  various  remedial  devices.  Among 
these  devices,  we  may  mention  the  creation  in  certain  cases 
of  organizations  designed  solely  to  act  as  intermediaries, 
and  in  many  cases  the  prohibition  of  combination  of  active 
and  passive  credit  business.    Where  such  prohibition  exists, 

"Op.  cit.,  Vol.  I,  pp.  48,  69;  Der  Credit,  Zweite  Halfte,  Berlin, 
1879,  pp.  217  ff.  As  was  pointed  out  in  the  preceding  section,  the 
many  fold  roots  of  banking  make  the  question  of  choice  between 
the  various  sources  primarily  a  matter  of  emphasis,  and  in  con- 
sequence no  general  agreement  exists  as  to  the  basic  source. 
Thus,  e.  g.,  Nasse  and  Lexis,  Handworterbuch  der  Staatswissen- 
schaften,  Zweiter  Band,  Zweite  Auflage,  Jena,  1899,  p.  132,  state: 
"In  diesem  Geschafte  (Kassenfiihrung)  wurzeln  die  geschaft- 
lichen  Anfange  alles  Bankbetriebes." 


22  BANKING   THEORY 

it  is  felt  that  capital  supply  and  the  system  of  payments 
must  be  dissociated.  Such  organizations  represent  an  at- 
tempt to  grapple  with  the  problem  anew,  by  means  of  spe- 
cial organizations  created  for  the  particular  purpose,  rather 
than  by  means  of  adaptation  of  older  existing  bodies.  Or- 
ganizations of  the  restricted  scope  just  mentioned,  however, 
are  of  little  importance  from  the  point  of  view  of  the  evolu- 
tion of  a  technique  for  the  supply  of  capital.  Instead,  they 
represent  rather  a  development  in  the  currency  system — an 
application  of  the  clearing  principle — and  in  the  administra- 
tion of  the  funds  of  the  individual  business  enterprise,  in 
which  character  they  act  as  a  species  of  fiscal  agent,  per- 
forming what  has  been  conventionally  described  as  Kassen- 
fiihrung.12  It  should  be  noted  that  organizations  so  re- 
stricted in  scope  sooner  or  later  enlarge  their  activities,  en- 
gaging in  loan  operations. 

More  important  for  our  purpose  is  the  gradual  rise  of  a 
distinct  institution  of  commercial  banking  as  contrasted 
with  an  institution  of  investment  banking,  and  the  gradual 
recognition  of  a  distinctive  character  appertaining  to  each. 
This  tendency  is  accompanied  by  a  tendency  towards  struc- 
tural cleavage  corresponding  broadly  to  the  functional  de- 
marcation. The  process,  however,  is  one  of  slow  evolution, 
and  presents  few  outstanding  features.  Continuing  through- 
out the  period  under  review,  it  is  also  found  in  the  succeed- 
ing period,  and  in  increased  degree.  In  fact,  the  recognition 
of  a  distinct  institution  of  commercial  banking  may  be  re- 
garded for  our  purpose  as  one  of  the  two  outstanding  fea- 
tures of  the  nineteenth  century. 

12  Ferhaps  the  best  known  illustration  is  afforded  by  the  Bank 
of  Amsterdam.  Mention  should  also  be  made  of  the  Italian 
banks  centuries  before,  likewise  of  the  goldsmith  bankers  in  their 
early  days,  though  the  last  named  were  of  course  of  a  strictly 
private  character. 


THE   EVOLUTION    OF    BANKING  23 

A  characteristic  of  the  modern  institution  of  commercial 
banking,  found  also  in  certain  cases  in  investment  banking, 
is  the  application  of  the  credit  principle  to  the  currency 
system — concretely,  the  use  of  credit  instruments  as  cur- 
rency, and  more  particularly  for  our  purpose,  the  use  of 
banking  obligations  in  this  fashion.  This  acceptance  o£ 
banking  credit  as  currency  is  but  the  logical  outgrowth  of 
the  recognition  of  a  distinctive  position  occupied 
by  banking,  which  was  previously  remarked.  The  evo- 
lution of  credit  currency  and  the  control  thereof  by  banking 
is  the  outstanding  feature  of  the  period  under  review. 
Highly  significant  for  our  purpose,  too,  is  the  fact  that  the 
currency  system  thus  at  the  same  time  has  become  a  means 
whereby  capital  is  loaned.13  Were  this  feature  absent,  the 
technique  of  capital  supply  might  conceivably  be  far  differ- 
ent than  it  now  is.  Viewed  merely  as  a  process  whereby 
capital  is  supplied,  banking  is  entirely  possible  where  money, 
and  not  credit  currency  supplied  by  it  is  in  use.  Money 
would  then  be  received,  credited  to  the  depositor's  account, 
and  loaned  to  another,  who  took  it  away.  This  is  in  fact 
the  original  form,  and  provides  the  older  conception.14  The 
modern  process,  however,  is  far  subtler,  as  will  be  indicated 

13  The  place  of  this  development  in  currency  evolution  may  be 
indicated  as  follows:  In  the  evolutionary  process  four  stages 
(abstracting  from  inconvertible  paper  money)  may  be  roughly 
recognized,  each  marked  by  the  appearance  of  the  form  noted,  in 
addition  to  those  previously  in  existence,  (1)  commodity  money 
(2)  government  representative  and  convertible  paper  money  (3) 
bank  notes  (4)  bank  deposits.  The  cleavage  of  great  significance 
for  the  student  of  banking  appears  between  the  second  and  third 
stages,  due  to  the  change  in  the  issuer.  It  is  here  that  we  remark 
the  coalescence  of  capital  supply  and  currency. 

"Subsequent  to  the  deposit  for  safe-keeping  only.  For  a 
statement  of  this  well  known  point,  cf.  Wagner,  Beitrage  zur 
Lehre  von  den  Banken,  Leipzig,  1857,  pp.  49-50. 


24  BANKING   THEORY 

at  greater  length  below.  Suffice  it  here  to  point  out  that  in 
the  use  of  banking  obligations  as  currency,  the  bank  relin- 
quishes its  rights  to  another  party  before  control  over  any 
capital  whatsoever  is  actually  transferred  to  it,  and  a  re- 
versal of  the  time  sequence  in  the  loan  operation  appears 
to  result.  We  see  here  clearly  that  only  through  consider- 
ation of  historic  origins  and  development  may  we  arrive  at 
a  proper  understanding  of  the  interrelations  of  the  three  C's 
— credit,  capital  and  currency — in  the  modern  economic 
order.15 

The  further  question  arises  of  the  form  which  the  credit 
currency  shall  assume.  To  the  student  of  banking  at  the 
present  day,  the  substantial  indentity  of  notes  and  deposits 
is  practically  a  truism,  the  clearest  method  of  proof  of  the 
same  treating  the  difference  between  the  two  forms  as  one 
of  accounting  technique,  in  that  with  the  one  form  merely 
one  general  account — notes  outstanding — is  written  on  the 
ledger,  instead  of  separate  accounts  with  each  of  the  indi- 
vidual creditors.  Changes  in  the  aggregate  amount  alone 
are  noted.  From  this  point  of  view,  the  difference  between 
notes  and  deposits  is  substantially  similar  to  that  between 
coupon  and  registered  bonds.  In  view  of  the  well-known 
fact  that  the  deposit  represents  the  earlier  form  historically, 
it  becomes  interesting  to  inquire  into  the  reasons  for  the  less 

15  The  customary  approach  is  illustrated  in  the  following  quo- 
tation from  J.  M.  Keynes,  in  his  review  of  Hobson,  Gold,  Prices 
and  Wages,  Economic  Journal,  Vol.  XXIII,  1913,  p.  396.  "The 
second  confusion  ...  is  between  the  two  senses  of  the 
word  'credit,'  the  sense  in  which  it  stands  for  the  method  by 
which  the  control  of  liquid  wealth  is  temporarily  transferred 
from  those  who  have  less  need  of  it  to  those  who  have  more, 
and  the  sense  in  which  it  stands  for  methods  of  making  payment 
and  effecting  exchanges  without  the  use  of  actual  coin.  There 
is,  of  course,  no  necessary  connection  whatever  between  these 
two." 


THE   EVOLUTION    OF   BANKING  25 

rapid  growth  of  the  earlier  device  during  the  period  under 
review,  and  the  rapid  rate  at  which  it  has  forged  ahead 
during  the  second  half  of  the  nineteenth  century.  Why 
did  the  deposit  system,  first  in  the  field,  lag  behind  in  the 
early  stages,  so  that  the  rise  of  the  note  system  was  an 
outstanding  feature  of  the  eighteenth  century,  and  why  has 
it  since  been  succeeded  by  the  deposit  system  as  the  prin- 
cipal factor  in  the  currency  system? 

It  becomes  necessary  at  the  outset  to  distinguish  clearly 
between  evidence  of  the  existence  of  the  obligation  and  the 
means  of  transferring  the  same.  Under  the  deposit  sys- 
tem, there  are  two  corresponding  constituent  elements,  the 
statement  of  the  account  and  the  cheque;  under  the  note 
system  both  are  combined  in  the  note.  These  are  present 
both  in  the  earlier  form,  in  which  there  has  been  a  prior 
deposit,  and  in  the  modern  form,  in  which  the  initial  deposit 
is  dispensed  with.  In  satisfying  the  need  for  an  increased 
circulating  medium  by  means  of  the  more  economical  prin- 
ciple of  credit  currency,  the  line  of  social  least  resistance 
would  naturally  be  followed.  This  demanded,  as  most 
closely  related  to  the  existing  currency  system,  a  form  of 
currency  which  combined  both  evidence  of  the  obligation 
and  means  of  transfer  thereof,  and  thus  would  circulate 
from  hand  to  hand.  The  factor  is,  of  course,  basically 
psychologic  and  sociologic  in  character.  This  currency 
system,  in  which  the  note  is  chiefly  employed,  implies  a 
situation  in  which  there  is  lack  of  differentiation  between 
commercial  and  investment  banking.  By  means  of  the  note, 
the  savings  of  the  people  are  gathered  and  transmitted  to 
business  enterprises,  rather  than  cooperation  effected  among 
the  latter  with  respect  to  their  circulating  capital  resources 
and  requirements.  Attention  is  called  to  the  desirability  of 
the  second  species  of  cooperation  wThen  increased  capital 
equipment  is  required,  and  hence  the  great  turning  point 


26  BANKING   THEORY 

is  afforded  by  the  Industrial  Revolution.  Inasmuch  as  the 
deposit  system  is  recognized  as  superior  for  the  business  en- 
terprise, and  hence  its  employment  accompanies  the  opera- 
tion of  commercial  banking  on  a  widespread  scale,  it  may 
be  regarded  as  a  concomitant  of  the  Industrial  Revolution. 
Moreover,  in  the  transition  to  distinct  institutions  of  com- 
mercial banking  and  investment  banking,  with  increased 
stress  placed  upon  the  instrumental  good,  and  the  rise  of 
business  enterprises  dealing  exclusively  therein,  the  influ- 
ence exercised  by  the  business  world  in  the  determination 
of  the  technique  of  currency  supply  is  increased,  and  the 
consuming  public  occupies  a  less  important  role  in  this  re- 
spect than  previously.  It  should  be  remarked  that  the  value 
of  the  deposit  system  for  the  business  enterprise  is  seen  also 
in  the  not  inconsiderable  development  of  it  which  occurred 
in  the  period  in  which  the  great  growth  of  the  note  system 
took  place. 

4.  The  outstanding  features  of  the  nineteenth  century 
for  our  purpose  are  the  rise  of  a  distinctive  institution  of 
commercial  banking,  and  the  change  from  the  note  system 
to  the  deposit  system  which  accompanied  it.  Both,  how- 
ever, represent  an  accelerated  pace  of  a  development  which 
had  already  commenced,  rather  than  a  strictly  new  phenom- 
enon. Having  considered  the  transition  from  the  note  to 
the  deposit  system,  and  the  relations  thereof  to  the  evolution 
of  the  institution  of  commercial  banking,  we  may  turn  now 
to  the  rise  of  commercial  banking  itself. 

In  modern  economic  society  there  is  a  gap  in  time  between 
the  sale  of  a  good  and  the  payment  of  the  purchase  price 
by  the  purchaser.  The  origins  of  the  gap  in  time — the  prin- 
cipal motive  forces  behind  its  development — are  complex, 
and  various  explanations  may  be  advanced.  Chief  among 
these  are  (1)  currency  difficulties,  and  the  desire  to  econo- 
mize in  the  use  of  commodity  money,  thus,  for  example, 
permitting  the  cancellation  of  indebtedness  at  the  fairs  by 


THE    EVOLUTION    OF   BANKING  27 

application  of  the  clearing  principle,16  (2)  difference  in 
location  of  buyer  and  seller,  and  transportation  difficulties 
encountered,  and  (3)  difference  in  relative  economic 
strength  of  buyer  and  seller,  the  middleman  gradually  ac- 
quiring the  ascendency  in  the  financing  process."  The  last 
named  factor  is  of  course  to  be  taken  in  conjunction  with 
the  increased  demands  for  capital  equipment  called  forth  by 
the  modern  order,  as  well  as  with  the  fact  that  with  pro- 
duction for  a  market  the  enterprises  in  the  various  stages 
in  the  economic  process  are  forced  to  invest  in  a  stock  of 
goods  and  in  the  later  stages  at  least  can  only  effect  payment 
therefor  as  part  of  this  stock  is  sold.  More  important  for 
our  present  purpose,  however,  is  it  to  remark  that  at  the 
present  time  the  gap  in  time  roughly  corresponds  to  the  pro- 
duction period — the  time  required  to  pass  the  goods  through 
the  buyer's  stage  of  the  economic  process.  The  number  of 
these  stages,  while  increased,  has  become  relatively  stand- 
ardized, as  well  as  the  time  required  to  pass  the  goods 
through  each  stage,  both  purely  marketing  and  industrial, 
the  latter  of  which  has  been  standardized  by  the  Industrial 
Revolution.  The  conception  derived  from  foreign  trade, 
which  is  still  prevalent  to  some  extent  in  that  sphere  today 18 
— that  the  time  should  be  sufficient  to  place  the  goods  in 
stock — is  discarded.  The  implication  of  a  regular  economic 
process,  divided  into  a  series  of  stages,  conventionally 
typified  by  manufacturer,  whoesaler  and  retailer,  represents 
a  change  in  the  conception  of  the  economic  process — as  pre- 

*«Cf.  Ehrenberg.  op.  cit.,  Vol.  II,  pp.  111-112. 

"This  is  a  familiar  phenomenon.  Cf.,  e.  g.,  Usher,  The  Pa- 
risian Bill  Market  in  the  Seventeenth  Century,  Journal  of  Po- 
litical Economy,  Vol.  XXIV,  1916,  pp.  993-994;  Shaw,  Some 
Problems  in  Market  Distribution,  Cambridge,  1915,  pp.  69ff;  Som- 
bart,  The  Quintessence  of  Capitalism  (translated  and  edited  by 
M.  Epstein),  London,  1915,  pp.  93ff.  The  point  is  closely  related 
historically  to  the  transition  from  domestic  to  factory  system. 


28  BANKING   THEORY 

viously  pointed  out,  it  becomes  the  production  of  wealth, 
not  merely  its  circulation.  There  is  a  regular  and  recur- 
ring flow  of  goods  from  raw  material  to  ultimate  consump- 
tion good. 

The  existence  of  the  gap  in  time  means  that  ordinary 
business  enterprises  in  many  cases  borrow  part  of  the  cir- 
culating capital  they  require.  This  capital  it  has  become 
the  function  of  commercial  banking  to  supply,  which  medi- 
ates in  first  instance  between  buyer  and  seller  in  adjacent 
stages  in  the  economic  process.  Commercial  banking  thus 
represents  a  specialized  technique  for  the  distribution  of  the 
existing  circulating  capital  of  society,  accomplishing  its 
function  through  bridging  the  gap  in  time  existing  between 
the  sale  of  a  good  and  the  payment  of  the  purchase  price  by 
the  purchaser.  Whereas,  in  the  case  of  the  sale  on  time, 
the  loan  which  in  effect  results  is  made  only  by  the  enter- 
prise with  which  the  buyer  has  direct  dealings,  through  the 
institution  of  commercial  banking  the  total  circulating  capi- 
tal resources  of  society  are  potentially  available  to  meet  his 
needs.  For  the  individual  business  enterprise,  the  borrow- 
ing which  occurred  rather  as  a  last  resort  in  earlier  times 
now  becomes  part  and  parcel  of  its  regular  operations.  It 
must  be  understood,  however,  that  this  development  is  at 
present  in  process  of  working  itself  out.  By  no  means  does 
it  represent  an  end  which  has  been  achieved,  but  rather  a 
goal  towards  which  the  events  of  the  near  past  have  shaped 

18  Cf.  Wolfe,  Foreign  Credits,  Special  Agents  Series  No.  62, 
Bureau  of  Foreign  and  Domestic  Commerce,  1913,  p.  114,  who 
states  that  "the  major  portion  of  American  manufacturers  willing 
to  grant  credit  abroad  are  wisely  in  favor  of  restricted  credit 
terms,  sufficient  to  allow  the  customer  to  receive  his  goods,  ex- 
amine them,  and  place  them  in  stock."  In  this  sphere,  however, 
it  represents  at  the  present  time  rather  a  device  to  force  the 
buyer  to  obtain  accommodation  at  his  local  bank,  instead  of  rely- 
ing upon  the   exporter. 


THE   EVOLUTION    OF   BANKING  29 

themselves,  and  towards  which  such  events  are  at  present 
directed.  As  yet,  the  pooling  is  partial,  and  is  much  more 
widespread  in  certain  directions  than  in  others.  An  empiri- 
cal process  of  realization  is  taking  place.  It  should  be  re- 
marked that  by  no  means  has  the  process  been  merely  one 
of  expansion,  more  or  less  gradual,  of  the  area  within 
which  cooperation  in  the  gathering  and  distribution  of  cir- 
culating capital  takes  place,  but  that,  accompanying  this  in- 
crease in  area,  there  has  been  evolution  in  the  technique  by 
which  this  cooperation  is  effected. 

The  change  mentioned  above  in  the  conception  of  the 
economic  process  typifies — interprets — an  actual  change  in 
the  economic  process  itself.  Moreover,  this  change  in  eco- 
nomic conditions  has  paralleled — has  both  rendered  possible 
and  rendered  desirable — the  development  of  the  institution 
of  commercial  banking.  Let  us,  therefore,  consider  certain 
of  the  well-known  phenomena  in  the  economic  transition 
from  this  point  of  view.19  Mention  has  been  made  above  of 
the  element  of  certainty  introduced  into  economic  life;  the 
risk  element  has  been  reduced  to  a  relatively  more  or  less 
calculable  basis.  The  contrast  between  mediaeval  and  mod- 
ern conditions  may  be  exemplified  in  the  contrast  between 
the  spice  trade  and  the  steel  industry.  At  the  same  time, 
the  modern  economic  process  in  its  industrial  phases  is 
rhythmic  rather  than  strictly  regular  in  a  static  sense,  and 
regular  ebb  and  flow  occurs.  Hence  a  cooperative  applica- 
tion of  the  social  circulating  capital  will  be  desirable.  More- 
over, the  field  included  has  broadened.  In  place  of  the  cus- 
tomary industrial  economy  of  the  Middle  Ages  in  general 
unsuited  to  a  pooling  arrangement,  in  part  at  least  because 
of  lack  of  change  in  minimum  and  maximum  capital  needs, 

19  It  will  be  observed  that  the  discussion  which  follows  deals 
largely  with  industrial  organization  and  production,  whereas 
the  previous  discusion  was  confined  primarily  to  marketing. 


30  BANKING   THEORY 

and  with  its  smaller  sphere  of  trade  unsuited  because  of  the 
risk  element,  we  have  now  a  regularized  and  rhythmic  pro- 
cess extending  broadly  throughout  our  economic  life. 

The  increase  in  productivity  may  next  be  mentioned.  This 
coincides  broadly  with  the  transition  from  an  agricultural 
to  an  industrial  society.  In  the  agricultural  stage  the  sur- 
plus above  the  existence  minimum  is  small.20  It  is  obvious 
that  with  a  small  social  product,  confined  largely  to  neces- 
sary consumption  goods,  there  is  little  field  for  the  opera- 
tion of  commercial  banking.  The  opportunity  is  afforded 
by  the  rise  of  the  intermediate  good  resulting  from  the 
change  in  the  technical  processes  of  industry,  in  equipment 
and  in  consequent  organization,  which  constitute  in  a  broad 
way  what  is  termed  the  Industrial  Revolution.  We  need  not 
concern  ourselves  with  the  controversy  as  to  whether  or  not 
the  process  has  been  lengthened,  and  the  ingenious  attempts 
which  have  been  made  at  reconcilement  of  the  two  oppos- 
ing views.21  Significant  for  our  purpose  is  the  fact  that 
there  has  been  both  an  increase  in  the  amount  of  capital  re- 
quired by  the  individual  enterprise,22  and  a  change  in  the 
nature  of  this  capital  equipment.  From  the  first  point  of 
view  we  may  say  that  the  history  of  the  corporation,  repre- 
senting as  it  does  modern  large  scale  industry,  is  the  history 
of  commercial  banking.  Pressure  for  additional  capital 
causes  economy  in  the  application  of  the  available  supply. 
It  should  be  noted  also  that  the  absolute  amount  of  circu- 

20Otherwise  stated,  in  the  industrial  stage  a  smaller  proportion 
of  the  population  care  for  the  bare  wants  of  subsistence  of  all. 

21  Cf.,  e.  g.,  Sombart,  Der  moderne  Kapitalismus,  Leipzig,  1902, 
Vol.  II,  pp.  70ff. 

22  The  superior  flexibility  from  the  point  of  view  of  the  indi- 
vidual business  enterprise  of  the  system  of  cooperation  over  that 
of  direct  holding  of  maximum  capital  requirements  is  readily 
apparent. 


THE  EVOLUTION   OF  BANKING  31 

lating  capital  required  tends  to  increase,  due  to  the  fact 
that  industry  is  now  based  upon  production  for  a  market. 
Production  to  order  requires  stocking  up  only  with  raw  ma- 
terial; production  for  a  market  requires  in  addition  an  in- 
vestment in  fluid  capital  representing  outlays  for  wages. 
Moreover,  the  advantages  arising  from  cooperative  applica- 
tion of  the  social  circulating  capital  may  well  be  enhanced 
where  such  production  for  a  market  is  the  general  practice. 
On  the  other  hand,  it  is  important  to  note  that  fixed  capital 
now  takes  its  place  alongside  circulating.  With  the  increase 
in  the  proportion  of  fixed  to  circulating  capital,  a  coopera- 
tive holding  of  circulating  capital  is  rendered  possible.  The 
phenomenon,  of  course,  is  psychologic,  while,  at  the  same 
time,  the  process  also  involves  greater  socialization  of  pe- 
cuniary relations.  We  see  that,  while  exchange  has  ordi- 
narily been  conceived  of  as  the  peculiar  sphere  of  commer- 
cial banking,  and  the  economic  texts  treat  the  latter  in  con- 
nection with  the  exchange  of  wealth,  it  is  the  rise  of  mod- 
ern industry  which  has  carried  in  its  wake  the  rise  of  the 
institution  of  commercial  banking. 

The  change  which  has  been  indicated  is  typified  by  change 
in  relative  importance  assigned  to  collateral  loan  and  com- 
mercial loan.  The  loan  during  the  earlier  part  of  the  de- 
velopment, due  perhaps  in  considerable  measure  to  lack  of 
confidence,  was  predicated  upon  collateral  in  the  form  of 
actually  existing  goods  having  a  more  or  less  ready  mar- 
ket. Where  this  type  of  loan  is  predominant,  we  generally 
find  prevalent  a  pawnshop  conception  of  banking — the  idea 
of  "coining  wealth  into  purchasing  power,"  as  it  has  been 
phrased.23    It  is  only  later  that  we  have  the  conception  of 

28  The  examples  of  this  conception  are  far  too  numerous  for 
complete  mention.  Among  the  relatively  later  instances  should 
be  noted  the  frequent  attempts  to  base  currency  upon  land,  the 
notes  to  be  issued  to  those  who  turned  in  the  lands.    The  specific 


32  BANKING   THEORY 

an  institution  of  commercial  banking  standing  in  a  regular 
and  definite  relation  to  the  economic  process,  assisting  in 
the  passage  of  goods  through  the  stages  of  the  process, 
and  in  so  doing,  making  cooperative  application  of  the 
circulating  capital  held  by  society. 

5.  Coincident  with  the  rapid  growth  of  the  institution  of 
commercial  banking  during  the  last  half  of  the  previous 
century  has  been  the  development  of  the  institution  of  in- 
vestment banking.  We  have  remarked  above  the  gradual 
recognition  of  the  distinctive  character  of  each  of  these  in- 
stitutions, aided  in  considerable  part  by  disastrous  experi- 
ences arising  from  a  lack  of  such  recognition  in  loan  opera- 
tions. But  it  is  only  with  the  advent  of  the  Industrial 
Revolution  that  investment  banking  has  assumed  promi- 
nence. The  increase  in  the  amount  of  the  capital  equip- 
ment required  and  in  the  scale  of  enterprise  which  occurred 
with  the  change  in  industrial  technique  is  well  known. 
Moreover  a  change — from  lending  to  participation — occurs 
in  the  technique  whereby  such  capital  is  supplied.  The 
widespread  adoption  of  the  joint  stock  principle,  due  per- 
haps in  large  part  to  pressure  for  capital  equipment  as  well 
as  to  certain  legal  advantages,  provided  a  fertile  field  for 
the  institution.  In  fact,  we  may  say  that  the  history  of  the 
corporation  is  also  the  history  of  investment  banking.  Aux- 
iliary hereto,  we  have  witnessed  the  growth  of  the  institu- 
tion of  the  security  market,  designed  both  to  assist  the  flow 
of  capital  into  investment  and,  just  as  important,  to  enable 

doctrinal  origins  of  the  various  forms  assumed  by  the  concep- 
tion will  be  indicated  at  the  appropriate  stages  of  the  exposition. 
Cf.  pp.  58,  66,  70,  74,  133.  The  conception  may  be  univer- 
salized as  the  coining  of  future  prospects  into  present  purchasing 
power.  The  instance  noted  the  text  then  becomes  a  special 
case,  involving  finished  goods  which  merely  need  a  market  to 
represent  an  actual  contribution  to  the  social  product.  This  mar- 
ket, of  course,  may  be  readily  available  or  not. 


THE  EVOLUTION  OF  BANKING  33 

liquidation  by  those  who  have  invested.  The  security  mar- 
ket and  investment  banking  have  become  complementary 
factors  in  the  pool  of  investment  financing,  together  medi- 
ating between  the  body  of  investors  on  the  one  hand  and  the 
body  of  business  enterprises  on  the  other. 


CHAPTER  II 

BANKING  IN   THE   PRESENT   ECONOMIC   ORDER 

1.  In  1892,  Karl  Menger  wrote  as  follows:  "The  enig- 
matic phenomenon  of  money  is  even  at  this  day  without 
an  explanation  that  satisfies ;  nor  is  there  yet  agreement  on 
the  most  fundamental  questions  of  its  nature  and  functions. 
Even  at  this  day  we  have  no  satisfactory  theory  of 
money."  x  Well  might  this  observation  be  applied  to  the 
present  status  of  banking  theory.  The  confusion  existing 
in  this  field  is  seen  in  the  multiplicity  of  existing  defini- 
tions of  banking.  While  great  diversity  is  exhibited,  these 
definitions  may  conveniently  be  classified  as  belonging  to 
one  of  several  types.2  First  may  be  mentioned  those  based 
upon  the  principle  of  enumeration  of  operations  conducted. 
As  is  well  known,  these  consist  usually  in  the  statement 
that  banking  performs  the  two  functions  of  acting  as  agency 
for  the  gathering  of  savings  and  for  creating  part  of  the 
medium  of  exchange,3  or  else,  shifting  to  another  level  of 
the  analysis,  in  a  listing  of  the  three  devices  by  means  of 
which  the  two  operations  just  enumerated  are  performed — 

1  On  the  Origin  of  Money,  Economic  Journal,  Vol.  II,  1892, 
p.  240. 

2For  another  classification,  cf.  Moulton,  Commercial  Banking 
and  Capital  Formation,  I,  Journal  of  Political  Economy,  Vol. 
XXVI,  1918,  pp.  490  ff. 

3Cf.  Taussig,  Principles  of  Economics,  New  York,  1911,  Vol. 
I,  p.  331.  Compare  also  White,  Money  and  Banking,  Fourth  Edi- 
tion, Boston,  1911,  p.  193,  who,  however,  leans  somewhat  to  the 
third  type;  and  von  Mises,  Theorie  des  Geldes  und  der  Umlaufs- 
mittel,  Miinchen  und  Leipzig,  1912,  p.  297,  who  introduces  also 
the  idea  of  receipt  and  extension  of  credit  by  banking. 


BANKING  IN   THE   PRESENT   ECONOMIC  ORDER  35 

Dunbar's  renowned  deposit,  discount  and  issue.  Second 
may  be  mentioned  those  which  select  a  single  characteristic 
believed  to  possess  peculiar  significance.  Mention  may  be 
made  here  of  the  view  of  Willis,  who  considers  banking 
"  a  special  mechanism  for  measuring  and  testing  credit  and 
determining  its  apportionment."4  The  third  type  consists 
of  attempts  to  select  a  technical  feature  of  operation  where- 
by it  may  be  possible  to  give  logical  coherence  to  the  diverse 
activities  enumerated  under  the  first  head.  This  usually 
consists  in  selecting  the  "creation"  of  loanable  funds  which 
have  as  a  basis  certain  cash  resources  in  the  possession  of 
the  bank.6 

It  will  be  remarked  that  those  who  employ  definitions 
of  the  above  character  in  general  confine  their  conception 
of  banking  to  commercial  banking,  and  the  definition  in 
effect  becomes  a  definition  of  commercial  banking.  But 
another  problem  arises  at  this  point.  While  the  other  con- 
ception has  approached  banking  from  the  side  of  credit,  and 
the  traditional  sphere  of  banking  has  been  in  exchange,  the 
rise  of  the  corporation  and  the  increasing  importance  at- 
tached to  raising  its  permanent  capital  equipment  has  caused 
serious  doubt  in  many  minds  as  to  the  legitimacy  of  this 
approach.  Banking  concerns  itself  with  investment  as  well 
as  with  commercial  operations;  it  is  a  two- fold  institution. 
But  how  is  this  to  be  brought  within  the  realm  of  banking 
as  ordinarily  defined?  Two  solutions  have  been  proposed. 
The  first  has  been  stated  by  Moulton  as  follows :    "It  is  im- 

4  In  an  unpublished  lecture.  Compare  his  statement  of  the 
guaranty  function  of  banking,  Ch.  IV,  Section  1.  Dealing  in 
credit  is  frequently  selected.  Cf.,  e.  g.,  MacLeod,  The  Theory  and 
Practice  of  Banking,  6th  Ed.,  Vol.  I,  London,  1902,  pp.  318-321, 
also  Hawtrey,  Currency  and  Credit,  London,  1919,  pp.  4,  191,  who 
leans  also  to  the  third  type. 

5  Cf.,  e.  g.,  Moulton,  op.  cit.,  pp.  497,  508,  who  distinctly  limits 
the  definition  to  commercial  banking,  when  viewed  "simply  as 
a  routine  business  organization." 


36  BANKING   THEORY 

possible  to  give  a  precise  definition  of  banking,  for  the 
reason  that  at  one  time  or  another  the  most  widely  differing 
economic  functions  or  services  have  been  designated  by  the 
term.  Even  now  it  includes  various  forms  of  financial  oper- 
ations based  on  substantially  different  principles."6 

On  the  other  hand,  we  may  hold  to  the  view  of  a  com- 
mon element,  which  we  may  note  in  fact  is  tacitly  implied 
in  the  above  quotation  from  Moulton  in  the  use  of  the  term 
"financial."  This  has  usually  been  found  in  the  economic 
service  of  banking  as  intermediary  in  the  supply  of  capital. 
This  definition  of  banking  is  in  the  view  of  those  ascribing 
to  the  doctrine  inclusive  enough  to  cover  both  commercial 
and  investment  operations.  The  view  came  to  prevail  in 
modern  Germany  with  the  rapid  growth  of  industrial  con- 
centration and  the  resulting  increase  in  the  activities  of  the 
great  banks  in  the  financing  of  industry,  and  it  has  been 
developed  in  particular  in  a  series  of  studies  dealing  with 
investment  banking  organizations  and  activities.  Found  in 
varying  forms  in  the  works  of  Plenge,7  Weber,8  and  Ries- 
ser,9  it  has  been  perhaps  most  fully  developed  by  Lief- 

6  Principles  of  Money  and  Banking,  Chicago,  1916,  Fart  II, 
p.  3.  Cf.  also  Wagner,  Der  Kredit  und  das  Bankwesen,  Schon- 
berg,  Handbuch  der  Politischen  Oekonomie,  Vierte  Auflage,  Er- 
ster  Band,  Tubingen,  1896,  p.  456.  This  is  the  same  line  of  argu- 
ment as  Jevons,  Money  and  the  Mechanism  of  Exchange,  New 
York,  1907,  pp.  242-5,  when  he  speaks  of  the  futility  of  attempting 
a  definition  of  money.  The  view  is  implied  in  Knapp's  treat- 
ment, Staatliche  Theorie  des  Geldes,  Leipzig,  1905,  p.  117. 

7  Griindung  und  Geschichte  des  Credit  Mobilier.  Zwei  Kapitel 
aus  Anlagebanken,  eine  Einleitung  in  die  Theorie  des  Anlage- 
bankgeschaftes,  Tubingen,  1903.  See  especially  pp.  29-34.  It  is 
interesting  to  note  that  the  earlier  work  of  Sattler,  Die  Effekten- 
banken,  Leipzig,  1890,  p.  1,  defines  banking  as  dealing  with  "the 
service  of  economic  institutions  as  intermediaries  in  monetary 
and  credit  exchanges."  To  the  earlier  Wagnerian  conceptions 
of  Geldbanken   und  Kreditbanken   he  adds  a   third  category — 


BANKING   IN   THE   PRESENT   ECONOMIC  ORDER  37 

mann.10  The  service  of  banks  has  become  "that  branch  of 
commerce  whose  peculiar  function  is  to  gather  fluid  capital, 
keep  the  same  in  stock,  and  place  it  at  disposal.  Banking 
is,  in  short,  dealing  in  fluid  capital  (Geldkapitalhandel) ." 
This  conception  of  banking  as  involving  the  supply  of  capi- 
tal is  as  old  as  the  classicists:  Ricardo  himself  implies  an 
acceptance  of  it,  though  he  does  not  expressly  state  it,11 
while  Mill  speaks  of  the  transfer  of  capital  already  in  exist- 
ence by  means  of  banks  of  deposit.12  The  view  is  also  found 
in  modern  works  stressing  the  credit  aspect  of  banking,  in 
some  of  which  a  separate  chapter  will  be  found  dealing  with 
the  economic  function  of  banking.1*  The  banker  "gathers 
capital  from  him  who  has  it  and  does  not  need  it,  and  trans- 
fers it  to  him  who  does  not  have  it  and  needs  it,"  to  quote 
one  of  these  versions. 

Which  of  these  definitions  are  we  to  choose?  Our  prob- 
lem is  not  simplified  by  the  fact  that  at  first  blush  there 
appears  to  be  an  element  of  truth  in  each.  The  key  to  the 
dilemma  is  this :  the  above  definitions  represent  an  attempt 
to  apply  the  older  logical  theory  to  evolutionary  problems 
for  the  solution  of  which  it  is  clearly  inadequate.14  The 
Janus-faced  character  of  banking — that  in  performing  one 
service  it  automatically  performs  another — which  we  re- 
marked in  the  previous  chapter,  represents  the  welding  to- 
gether of  several  phases  in  the  evolutionary  process.  Thus 
it  is  that  banking,  while  unified  and  organic,  is  nevertheless 
Effektenbanken.  The  continental  tendency  to  broaden  the  scope 
of  the  term,  as  contrasted  with  the  reverse  English  tendency,  is 
already  found  in  Knies,  op.  cit.,  pp.  215  ff. 

8  Depositenbanken  und  Spekulationsbanken.  Ein  Vergleich 
deutschen  und  englischen  Bankwesens.  Zweite,  neu  bearbeitete 
Auflage,  Miinchen  und  Leipzig,  1915.     Introduction. 

9  The  German  Great  Banks  and  their  Concentration  in  Con- 
nection with  the  Economic  Development  of  Germany.  National 
Monetary  Commission  Publications.    Ch.  1. 


38  BANKING   THEORY 

capable  in  a  sense  of  dissociation  into  several  parts  not 
strictly  logically  (according  to  the  older  logic)  related  to 
each  other.  It  is  at  once  several  things  according  to  the 
point  of  view  from  which  it  is  regarded.  The  phenomenon 
is  similar  to  the  psychologic  trick  of  an  image  carrying  with 
it  several  mental  suggestions  to  the  observer,  first  one  and 
then  the  other  being  uppermost,  though  the  object  itself 
does  not  change.15  The  futility  of  attempting  a  compre- 
hensive definition  will  be  readily  apparent.  In  place  of  aid- 
ing the  understanding  of  the  institution  of  banking,  which 
clarification  is  the  only  raison  d'etre  of  a  definition,  it  would 
serve  instead  to  confuse  the  matter.16  Hence  we  will  re- 
frain from  the  attempt.  Rather  will  it  be  more  profitable  to 
proceed  at  once  to  the  analysis  of  the  present  situation — 
having  seen  the  principal  features  in  the  evolution,  to  con- 
sider its  present  operation. 

2.     The  most  profitable  approach  to  our  analysis  of  the 

10  Op.  cit.,  p.  592. 

"Works,  McCulIoch's  2d  Ed.,  London,  1852,  p.  431.  "A  bank 
would  never  be  established,  if  it  obtained  no  other  profits  but 
those  from  the  employment  of  its  own  capital;  its  real  advan- 
tage comes  only  when  it  employs  the  capital  of  others." 

12  Principles  of  Political  Economy,  Ashley's  edition,  p.  513. 

13  Cf.,  e.  g.,  Conant,  Principles  of  Money  and  Banking,  New 
York  and  London,  1905,  Book  V,  Ch.  Ill,  and  Agger,  Organized 
Banking,  New  York,  1918,  Ch.  III. 

14  The  similarity  to  Alfred  Marshall's  statement  of  what  he 
terms  the  principle  of  continuity,  in  the  preface  to  the  first  edi- 
tion of  his  Principles  of  Economics,  will  be  readily  apparent. 
Cf.  Third  edition,  London,  1895,  p.  xiii. 

15  This  statement  applies  equally  to  money  also. 

16  If  it  be  argued  that  the  central  feature  of  a  definition  is  the 
selection  of  the  salient  characteristic,  mention  may  be  made  of 
the  "method  of  odd  cases,"  as  it  may  be  termed,  a  favorite  de- 
vice in  economic  argumentation  in  undermining  another's  at- 
tempt at  a  definition  possessing  sufficient  scientific  rigor. 


BANKING  IN   THE   PRESENT   ECONOMIC  ORDER  3(J 

position  and  operation  of  banking  in  the  present  economic 
order  will  be  to  regard  it  as  a  specialized  technique  in  the 
supply  of  capital.17  More  simply  phrased,  and  with  several 
of  the  implications  of  the  phrase  stripped  away,  it  may  be 
regarded  for  the  purpose  at  hand  as  commerce  in  capital. 
Considerable  analogy  may  be  drawn  between  commerce 
as  ordinarily  conceived  and  banking  as  commerce  in  a  spe- 
cial commodity,  whether  we  attempt  an  elaborate  analysis, 
such  as  that  of  Shaw  and  Weld,18  of  the  so-called  marketing 
"functions,"  or  whether  we  confine  ourselves  to  the  simpler 
triad  of  gathering  the  commodity,  keeping  the  same  in 
stock,  and  disposing  thereof.  The  differences,  however, 
are  just  as  marked  as  are  the  analogies,  in  particular, 
e.  g.,  with  respect  to  the  second  of  the  three  functions  enu- 
merated, and  especially  with  respect  to  commercial  banking 
and  to  investment  banking  in  which  the  commercial  banking 
principle  is  applied.19  This  accounts  for  the  fact  that  the 
chief  proponents  of  the  view  that  banking  is  to  be  consid- 
ered as  commerce  in  capital  have  been  students  whose  in- 
terest has  been  directed  largely  to  investment  banking. 
While  it  would  appear  that  the  most  fruitful  development  of 
the  conception  would  consist  in  an  analysis  of  the  manner 
in  which  banking  performs  the  various  "functions,"  this 
phase  has  generally  been  neglected,  or  else  treated  as  sub- 
ordinate. Liefmann,  who  has  discussed  the  matter  at  some 
length,20  has  a  different  approach,  and  considers  the  prob- 
lem merely  because  of  the  light  which  he  believes  it  throws 


17  Though  manifestly  partial,  as  we  have  indicated  in  Ch.  I,  it 
supplies  a  satisfactory  approach  for  the  present  problem. 

18  Shaw,  op.  cit.,  p.  76;  Weld,  Marketing  Functions  and  Mer- 
cantile Organization,  American  Economic  Review,  Vol.  VII, 
1917,  pp.  306-18. 

19  Cf.  Ch.  VI,  Section  3. 

20  Op.  cit.,  pp.  587ff. 


40  BANKING   THEORY 

upon  the  scope  of  banking.  Specifically,  the  central  prob- 
lem to  him  is  one  of  (delimiting  the  sphere  of  banking,  of  de- 
termining which  of  the  hetrogeneous  group  of  organiza- 
tions which  possess  in  common  alone  the  one  feature  of 
issuing  securities,  may  be  dignified  by  the  name  "bank," 
and  which  are  to  be  placed  without  the  pale.  The  problem 
is  complicated  by  the  structural  specialization  of  function 
pronounced  in  investment  banking,  which  accompanies  the 
fact  that  the  individual  holder  of  securities  bulks  large  in  the 
pool  of  investment  banking,  as  we  shall  see  below.21  As 
viewed  by  Liefmann,  the  problem  may  be  stated  as  follows : 
How  many  of  the  classes  of  activity  involved  in  marketing 
must  be  performed  by  an  organization  in  order  to  entitle  it 
to  the  name  "bank"  ?  This  is  really  the  old  philosophic 
problem,  is  the  whole  greater  than  the  sum  of  its  parts. 
The  phenomenon  of  subdivision  of  labor  certainly  should 
not  be  permitted  to  obscure  the  role  played  by  the  totality 
of  the  parts.  For  an  understanding  of  the  role  of  banking 
in  modern  economic  society,  the  problem,  as  we  have  indi- 
cated in  the  preceding  section,  is  of  no  significance.  Rather 
does  it  serve  to  show  the  inadequacy  of  the  mere  conception 
of  banking  as  commerce  in  capital,  and  point  to  the  need  of 
analyzing  the  relation  to  the  economic  process  in  which 
banking  in  its  action  in  this  capacity  is  placed.  Only  in  this 
manner  do  we  obtain  an  adequate  understanding. 

3.  This  involves  a  statement  at  the  outset  of  the  fea- 
tures which  are  of  significance  in  the  economic  process,  un- 
derstanding by  the  term  "economic  process"  all  the  activi- 
ties which  combine  to  produce  the  onward  sweep  of  goods 
from  producer  to  consumer.  This  economic  process  has 
been  conventionally  divided  into  stages,  designed  to  repre- 
sent the  condition  of  the  good  at  various  steps  in  its  evolu- 
tion from  raw  material  to  finished  product.22    This  device 

21  Section  5. 


BANKING   IN   TIIK    PRESENT   ECONOMIC   ORDER  41 

is  of  course  at  best  a  rough  schematization,  symbolic  rather 
than  strictly  accurate.  Yet  in  the  process  as  a  whole  cer- 
tain lines  of  division  may  be  rather  clearly  perceived.  Most 
fundamental  for  our  purpose  is  the  traditional  distinction 
of  the  classicists  between  production  and  exchange.  The 
former,  having  for  its  purpose  the  creation  of  potential  form 
utility,  may  again  be  subdivided.  Raw  materials  must  be 
extracted.  The  road  along  which  move  these  raw  materials, 
either  absolutely  raw,  such  as  iron  ore,  or  partly  manufac- 
tured, yet  destined  for  passive  service  in  the  technical  pro- 
cess, as  pig  iron,  has  two  branches.  According  to  the  direc- 
tion chosen,  the  finished  products  which  result  are  either 
intermediate  goods  or  consumption  goods.  While  the 
former,  as  is  also  the  case  with  what  are  destined  to  be  final 
consumption  goods,  but  as  yet  are  only  in  partially  finished 
form,  possess  only  derived  utility  arising  from  and  due  en- 
tirely to  the  utility  of  the  finished  products  which  will  be 
produced  by  them  or  into  which  they  will  be  converted,  for 
practical  purposes  the  derived  utility  which  they  thus  pos- 
sess for  the  manufacturer  or  dealer  who  purchases  them 
may  be  considered  as  occupying  the  same  position  as  the 
actual  utility — power  of  direct  satisfaction  of  desire — pos- 
sessed by  the  final  consumption  good.  Exchange  as  distinct 
from  production  consists  in  the  creation  of  potential  time 
and  place  utilities,  and  in  the  bringing  of  these  potential 
utilities  into  contact  with  users  of  the  goods,  so  that  actual 
utilities  result.  In  so  doing,  the  marketing  "functions"  we 
have  remarked  above  are  performed.  Nor  in  a  complex 
society  in  which  production  for  a  market  must  needs  pre- 
vail in  place  of  production  for  order,  may  the  importance  of 
these  "functions"  be  minimized.  The  application  of  the 
staging  conception  to  the  classical  conception  of  the  eco- 
nomic process  has  resulted  in  the  conventional  representa- 

22  As,  for  example,  by  Menger  and  J.  B.  Clark. 


42  BANKING   THEORY 

tion  of  the  process  by  a  series  consisting  of  the  producer 
of  raw  material,  the  manufacturer  or  fashioner  thereof 
into  the  finished  product,  the  wholesaler,  the  retailer,  and 
the  consumer.  The  first  two  are  concerned  chiefly  with 
the  creation  of  form,  the  third  and  fourth  with  the  creation 
of  time  and  place  utilities. 

The  distinction  here  made  between  production  and  ex- 
change is  roughly  that  known  to  the  business  world  between 
manufacturing  and  commerce.  Yet  the  term  "commerce" 
has  also  a  wider  connotation,  and  it  occurs  very  largely  in 
raw  materials  as  well.  It  is  here  that  concession  must  be 
made  to  the  structural.  Thus  far  we  have  considered  pri- 
marily the  economic  process  as  distinct  from  the  economic 
order.  But  the  economic  order  in  composition  does  not,  as 
we  have  hitherto  assumed,  exactly  correspond  to  the  eco- 
nomic process ;  structural  division  does  not  closely  parallel 
functional.  Not  only  has  subdivision  of  labor  cre- 
ated structural  agencies  which  specialize  in  partic- 
ular stages  of  the  process,  but  agencies  which 
confine  their  activity  entirely  to  the  marketing  "func- 
tion" are  to  be  found  in  the  stage  of  the  process  which  we 
have  classified  as  production.  Nor  is  specialization  of 
"function"  requisite ;  any  conceivable  combination  of  activ- 
ities may  exist,  provided  usually  merely  that  the  handling 
of  the  good  be  continuous.  Each  business  enterprise  in  the 
course  of  its  activity  goes  through  the  same  process  as  does 
society  as  a  whole  in  carrying  on  the  economic  process  in 
its  totality,  except  that  the  so-called  middlemen  omit  the 
manufacturing  process.  Each  enterprise  creates  not  only 
potential  but  actual  utilities  as  well.  Manufacturer  as  well 
as  middleman  creates  time  and  place  utilities.  Thus  he 
buys  what  for  him  may  be  termed  raw  materials,  manu- 
factures them  perhaps  into  more  refined  products,  and  mar- 
kets these  products.    The  burden  of  misdirection  of  his  pro- 


BANKING  IN   THE   PRESENT   ECONOMIC  ORDER  43 

ductive  activity  must  be  borne  by  him  alone.  Thus  is  the 
economic  process  reproduced  in  miniature.  This  involves 
for  each  economic  unit,  no  matter  where  in  the  economic 
process  as  a  whole  it  may  primarily  be  placed,  the  perform- 
ance of  all  the  "functions."  23 

4.  It  will  be  apparent  that  the  material  equipment  of  the 
business  enterprise  is  of  two  kinds.  First  is  the  material 
which  is  to  be  transformed  in  the  process — of  which  a  dif- 
ferent form  utility  is  to  be  created  by  the  manufacturer, 
and  which  itself  thus  passes  directly  stage  by  stage  through 
the  process  until  it  reaches  its  final  form  and  is  brought  to 
its  final  use.24  The  other  is  the  technical  equipment  re- 
quired, which  in  conjunction  with  goods  of  the  first  de- 
scription merely  yields  at  regularly  recurring  intervals  a 
series  of  products  which  pass  through  the  stages  in  the  pro- 
cess. In  brief,  the  distinction  is  between  passive  and  active 
employment  in  the  economic  process.  The  capital,  for 
such  it  is,  required  in  the  process,  must  be  divided  into  two 
kinds;  we  have  then  the  conventional  distinction  between 
circulating  capital  and  fixed  capital.25  Against  the  volume 
of  industrial  capital  or  capital  goods  just  mentioned  is  to 
be  set  the  volume  of  pecuniary  capital — the  expression  in 
terms  of  the  monetary  unit  of  the  current  valuation  placed 
upon  the  goods  which  it  represents.26  Significant  for  our 
purpose  is  the  fact  that  the  circulating  capital  of  the  busi- 
ness enterprise  is  held  now  in  industrial,  now  in  pecuniary 
form,  as  the  goods  are  in  process  of  manufacture,  or  have 
been  sold.  To  the  business  enterprise,  both  goods  in  works 
and  the  funds  received  from  sales  of  its  completed  product 

23  We  see  in  fact  that  the  marketing  "functions"  when  analyzed 
in  detail  supply  also  a  more  detailed  representation  of  the 
process  as  a  whole. 

24  It  will  be  apparent  that  only  time  and  place  utility  creation 
may  occur  in  the  later  stages. 


44  BANKING   THEORY 

represent  part  of  its  circulating  capital,27  and  there  is  con- 
tinual flow  from  one  form  to  the  other,  and  vice  versa,  as 
the  goods  in  question  complete  or  commence  their  passage 
through  its  stage  of  the  economic  process. 

The  relation  of  this  fact  to  the  duration  of  time  for 
which  the  capital  is  necessarily  supplied  is  obvious.  In  the 
one  case,  the  capital  is  again  available  in  pecuniary  form 
after  a  considerable  period  of  time,  as  the  successive 
usufructs  accumulate;  in  the  other,  its  pecuniary  value  is 
released  shortly.28  In  other  words,  the  one  in  the  absence 
of  certain  special  devices  is  necessarily  a  long  term  opera- 
tion, while  the  other  may  be  short.  The  period  in  the  latter 
case  represents  the  length  of  the  stay  of  the  goods  in  the 

25  While  the  distinction  is  in  some  respects  rather  tenuous, 
and  on  that  account  at  times  has  been  rejected,  the  fact  that  the 
ordinary  operations  of  the  business  enterprise  are  predicated 
upon  the  distinction  and  that  a  satisfactory  accounting  distinc- 
tion has  been  developed,  may  be  pointed  to  in  justification  of  its 
employment  in  the  present  connection. 

26  The  capitalization  theory  may  be  dismissed  thus  briefly,  as 
it  possesses  no  significance  for  the  problem  immediately  at  hand. 
Our  concern  here  is  rather  with  looking  backward  than  with 
looking  forward — at  the  past  and  its  events,  rather  than  at  the 
future. 

27  At  any  one  moment,  part  of  the  circulating  capital  equip- 
ment of  the  individual  enterprise  may  be  in  industrial,  part  in 
pecuniary  form,  as,  for  example,  in  the  case  of  a  tanner,  where 
part  may  be  represented  by  hides  and  part  by  "money"  to  be 
gradually  expended  for  wages  and  for  tanning  materials  em- 
ployed in  making  up  the  hides. 

28  This  is  merely  another  way  of  expressing  the  conventional 
conception  of  the  self-liquidating  character  of  the  commercial 
transaction.  This  distinction  itself  is  a  commonplace  in  eco- 
nomic literature.  Cf.,  e.  g.,  Knies,  op.  cit.,  pp.  301-2,  and  Walras, 
d'ficonomie  Politique  Applique,  Lausanne  et  Faris,  1898,£tudes 

pp.  313-316. 


BANKING   IN   THE   PRESENT  ECONOMIC  ORDER  45 

particular  stage  of  the  economic  process.  Thus  we  get  the 
conventional  conception  of  the  production  period,  though  it 
is  obvious  that  the  period  varies  from  business  to  business. 
Rather  may  the  several  periods  be  conceived  of  as  ranged 
in  a  frequency  distribution,  clustering  about  a  mode  or  aver- 
age type,  in  the  United  States  perhaps  about  sixty  to  ninety 
days,  and  with  the  great  majority  of  the  cases  falling  below, 
say,  six  months. 

The  capital  supplied  by  banking,  though  all  in  the  form 
of  liquid  purchasing  power  (free  or  floating  capital,  to  use 
Marshall's  term),  may  thus  be  of  two  kinds.  There  is  not, 
however,  exact  parallelism  between  the  cleavage  in  the 
banking  sphere  and  the  cleavage  in  the  capital  sphere.  While 
it  is  generally  stated  that  the  long  term  capital  supplied  is 
to  be  invested  in  certain  fixed  forms,  such  as  buildings  and 
machinery,  part  of  this  long  term  capital  may  be  employed 
by  the  recipient  enterprise  as  circulating  capital.  It  is 
with  the  supply  of  the  circulating  capital  alone  that  com- 
mercial banking  concerns  itself,  while  investment  banking 
involves  the  supply  of  both  forms.  In  brief,  the  pecuniary 
capital  supplied  by  commercial  banking  is  limited  to  use 
industrially  as  circulating  capital,  while  the  pecuniary  capi- 
tal supplied  by  investment  banking  is  available  for  use  in- 
dustrially as  either  fixed  or  circulating  capital.  As  every 
business  enterprise  requires  both  fixed  and  circulating  capi- 
tal, the  real  distinction  from  the  point  of  view  of  banking  is 
the  supply  in  the  case  of  commercial  banking  of  temporary 
advances  whose  manifestations  are  destined  to  be  shortly 
transferred  to  others,  and  the  advances  thereby  repaid,  and 
in  the  case  of  investment  banking  of  the  whole  or  part  of 
the  permanent  capital  equipment  of  the  enterprise. 

We  see,  then,  that  there  is  an  institution  of  banking  stand- 
ing in  a  definite  relation  to  the  economic  process.  While 
investment  banking  provides  more  particularly  the  setting 


46  BANKING   THEORY 

in  which  the  action  takes  place,  commercial  banking  is  con- 
cerned entirely  with  the  action  itself.  It  plays  its  role 
directly  in  the  evolution  of  the  economic  good  from  raw 
material  to  finished  product.  It  aids  directly  in  the  move- 
ment of  goods  in  the  economic  process.  This  it  accom- 
plishes by  bridging  the  gap  in  time  which  has  arisen  between 
the  sale  of  a  good  and  the  payment  of  the  purchase  price  by 
the  purchaser.  How  it  accomplishes  this  task  will  be  con- 
sidered in  the  chapters  to  follow.  While  exchange  has 
been  its  accredited  sphere,  we  see  that  this  holds  true  only 
if  the  term  "exchange"  be  broadened  to  include  any  trans- 
fer of  goods;  in  the  economic  process  as  a  whole,  it  medi- 
ates as  well  in  the  sphere  of  production  as  in  the  sphere  of 
exchange,  nor  is  its  position  in  the  sphere  of  production  one 
particle  less  vital.29  Furthermore,  it  touches  the  individual 
enterprise,  no  matter  what  its  nature,  both  at  the  commence- 
ment and  close  of  its  activity.  Commercial  banking  loans 
to  it  when  it  purchases  its  raw  materials,  and  enables  it  to 
secure  payment  at  once  when  it  sells  the  finished  product. 
5.  In  addition  to  the  destination  of  the  capital  supplied 
by  the  institution  of  banking,  the  sources  from  whence  the 
same  is  derived  must  also  be  considered.  To  do  this,  it  will 
be  desirable  to  approach  the  institution  of  banking  in  a 
somewhat  different  manner.  Consider  a  pool  of  commercial 
financing  and  a  pool  of  investment  financing.  The  pool  of 
commercial  financing  concerns  itself  with  the  social  circulat- 
ing capital,  the  pool  of  investment  financing  with  the  total 
capital  equipment  of  society,  both  fixed  and  circulating.  In 
the  pool  of  commercial  financing,  commercial  banking  plays 

29We  by  no  means  can  agree  with  Anderson's  narrow  con- 
ception of  commercial  banking  as  seen  in  his  definition  of  com- 
mercial paper.  Cf.  The  Value  of  Money,  New  York,  1917,  pp.  498 
ff.,  also  Moulton's  criticism  of  Anderson,  Commercial  Banking 
and  Capital  Formation,  II,  Journal  of  Political  Economy,  Vol. 
X7VI,  1918,  pp.  641-3. 


BANKING   IN   THE   PRESENT   ECONOMIC  ORDER  47 

a  far  larger  role  than  does  investment  banking  in  the 
pool  of  investment  financing.  Nor  is  the  pooling  which  is 
effected  of  exactly  the  same  character.  In  the  former  indi- 
vidual business  enterprises  are  the  units  between  which 
cooperation  in  the  main  is  effected,  temporary  surpluses 
of  capital  obtained  from  some  being  applied  to  temporary 
deficits  of  others ;  in  the  pool  of  investment  financing,  the 
lending  units  are  the  individual  investors  themselves,  capi- 
tal gathered  from  them  being  furnished  to  business  enter- 
prises.30 In  the  first  case,  mediation  is  effected  for  the 
business  community,  which  is  at  once  both  source  of  supply 
and  recipient  of  capital ; 31  in  the  second  case,  mediation  is 

30  A  contrast  which  is  similar  in  certain  respects  is  drawn  by 
Scott  between  the  functions  of  commercial  banks  and  investment 
banks.  Cf.  Investment  vs.  Commercial  Banking,  Proceedings  of 
the  Second  Annual  Convention  of  the  Investment  Bankers  Asso- 
ciation of  America,  1913,  pp.  76  ff.  Reprinted  in  part  in  Moultoa 
(editor),  Principles  of  Money  and  Banking,  Chicago,  1916,  Part 
II,  pp.  4-6. 

31  The  problem  of  how  far  banking,  or  any  part  of  it,  effects 
such  cooperation,  or  merely  effects  the  transfer  of  capital  from 
a  lending  to  a  borrowing  class,  has  been  indirectly  touched  upon 
by  various  writers.  Thus  Coquelin,  Le  Credit  et  les  Banques, 
2e  Edition,  Paris,  1859,  pp.  109-127,  regards  credit  as  a  means  of 
effecting  such  cooperation  between  the  mercantile  community, 
through  extension  of  credit  by  the  enterprise  in  each  stage  to 
the  enterprise  in  the  succeeding  stage  in  the  economic  process,  but 
regards  banks  merely  as  intermediaries  between  entrepreneurs 
and  capitalists.  The  above  doctrine  as  to  credit,  however,  leads 
him  to  approach  in  certain  particulars  the  views  mentioned  in 
Chapter  III,  Section  6,  and  Walras,  op.  cit,  pp.  316-318,  expresses 
strong  dissent,  holding  that  "credit  is  always  a  placement  (loca- 
tion) of  capital  with  an  entrepreneur  by  a  capitalist."  The  con- 
ception of  commercial  banking  given  in  the  text  corresponds  in 
broad  outline  to  the  first  category  of  Courcelle-Seneuil's  three- 
fold classification  of  banks.  Cf.  Les  Operations  de  Banque. 
Traite  Th6oretique  et  Pratique.  Huitieme  Edition,  revue  et  mise 
a  jour  par  Andre  Liesse.    Paris,  1899,  pp.  169-176. 


48  BANKING   THEORY 

effected  between  one  class  in  the  community  and  another 
distinct  class  from  which  the  former  receives  capital.  Cor- 
responding to  the  difference  in  purpose  is  a  difference  in  the 
technique  by  which  the  pooling  is  effected.  The  individual 
investor  directly  holding  the  securities  of  business  enter- 
prises— directly  participating  in  them  rather  than  merely 
lending  to  them — bulks  larger  in  the  pool  of  investment 
financing  than  does  his  counterpart,  the  enterprise  which 
sells  on  time,  or  which  purchases  and  holds  commercial 
paper  with  its  surplus  funds,  in  the  pool  of  commercial 
financing.  Otherwise  phrased,  representation  by  the  insti- 
tution of  commercial  banking  of  lending  business  enterprises 
plays  a  larger  role  in  the  pool  of  commercial  financing  than 
does  representation  by  the  institution  of  investment  banking 
of  individual  "investors"  in  the  pool  of  investment  financing. 
Hence,  the  organization  of  the  security  market  is  of  great 
importance  in  investment  financing,  whereas  in  commercial 
financing  the  discount  market  is  rather  regarded  as  a  prob- 
lem of  the  internal  organization  of  the  banking  system.32 


32  For  a   more   detailed   discussion   of   the  entire   question   cf. 
Ch.  VI,  Section  I. 


CHAPTER  III 


COMMERCIAL  BANKING 


1.  The  institution  of  commercial  banking  bridges  the 
gap  in  time  which  exists  in  modern  economic  society  be- 
tween the  sale  of  a  good  and  the  payment  of  the  purchase 
price.1  The  buyer 2  is  relieved  from  the  necessity  of  im- 
mediate payment,  while  the  seller  has  the  funds  at  once 
placed  at  his  disposal  for  use  when  he  may  so  desire.  The 
banking  system  in  effect  puts  these  funds  out  in  the  form 
of  goods,  i.  e.,  the  capital  it  supplies  is  invested  temporarily 
in  the  goods.  In  other  words,  the  buyer  is  supplied  with 
part  of  his  circulating  capital.  The  capital  of  the  seller  of 
the  goods  is  released  through  the  permission  granted  him 
to  draw  claims  upon  the  banking  system. 

But  where  does  the  banking  system  secure  these  funds 
which  it  places  at  the  seller's  disposal?  It  is  commonly 
held  that  it  calls  into  being  an  amount  of  purchasing  power 
on  the  basis  of  its  cash  holdings.  This  explanation  of  the 
fundamental  process  involved  is,  however,  erroneous.    The 

1  In  this  chapter,  unless  specifically  stated  to  the  contrary,  the 
term  "banking"  is  employed  in  the  sense  of  commercial  banking. 
As  will  be  readily  apparent,  the  analysis  has  been  made  with  the 
deposit  system  principally  in  mind,  although  similar  considera- 
tions apply  in  large  part  in  the  case  of  the  note  system  also. 

2  For  the  sake  of  ease  of  expression,  the  terms  "buyer,"  "seller" 
and  "borrower"  are  employed  in  the  discussion  which  follows.  It 
should  be  noted  that  the  same  refer  primarily  to  business  enter- 
prises rather  than  to  individuals,  although  we  have  yielded  to 
grammatical  usage  and  have  not  employed  the  neuter,  which 
strictly  should  be  done. 


50  BANKING   THEORY 

banking  system  supplies  actual  capital,  the  result  of  absten- 
tion from  the  consumption  of  values  previously  created.  It 
may  represent,  for  example,  the  fruits  of  past  labor,  or 
merely  the  result  from  the  sale  of  a  commodity  at  a  price 
higher  than  the  purchase  price.  The  immediate  source  of 
the  capital  is  best  seen  as  follows.  In  society  as  a  whole, 
there  is  at  any  moment  a  certain  amount  of  goods  to  be 
marketed.  Conceive  of  the  funds  used  in  this  process,  i.  e., 
to  bridge  the  gap  between  sale  and  payment  of  the  purchase 
price,  as  a  vast  pool.3  Into  this  pool  are  continually  flow- 
ing streams  of  capital  in  the  form  of  loans  to  buyers.  These 
streams  emanate  from  a  reservoir  which  represents  the 
banking  system.  But  it  is  the  source  of  replenishment 
of  the  reservoir  which  particularly  interests  us.  Out  of  the 
pool  and  into  the  reservoir  are  continually  flowing  streams 
of  capital — the  repayment  of  loans  by  purchasers  of  goods 
as  the  goods  are  again  sold  and  thus  passed  on  one  stage 
further  in  the  productive  process.  As  the  goods  upon  which 
the  loans  were  based  are  sold,  the  loans  are  repaid,  and  the 
capital,  other  things  being  equal,  again  raises  the  level  in 
the  reservoir.4  An  essential  point  which  will  be  considered 
at  greater  length  below  is  that,  whereas  in  the  supply  of 
long-term  capital  ultimate  borrowers  and  lenders  are  dis- 
tinct, in  the  supply  of  short-term  capital  the  ultimate  bor- 
rowers and  lenders  are  in  the  aggregate  practically  one  and 
the  same  body.  In  a  word,  they  are  the  entire  mercantile 
community  (in  the  broad  sense  of  the  term). 

The  conception  may  perhaps  be  clarified  by  a  consider- 
ation of  the  accompanying  diagrammatic  representation.  In 
simplest  form  we  have  merely  two  elements — the  pool  and 

8  In  the  present  discussion  we  abstract  from  the  direct  sale  on 
time,  in  which  the  seller  actually  supplies  the  required  funds,  also 
from  direct  holding  of  commercial  paper  by  business  enterprises. 

4But  cf.  Section  4  of  the  present  chapter. 


COMMERCIAL   BANKING 


51 


the  reservoir,  and  a  two-fold  connection  between  them. 
The  banking  system  directs  the  outflow  through  the  one 
connection,  and  receives  the  inflow  through  the  other.  The 
pool  may  profitably  be  further  analyzed.  Taking  a  cross- 
section  of  society  at  any  one  moment  of  time,  the  pro- 


BANKING 
SYSTEM 


IwheatH  flourJUbreadE 


ductive  process  is  seen  as  a  succession  of  stages.  Let  us 
assume  three  represented  respectively  by  the  producer  of 
raw  material,  such  as  wheat,  the  fashioner  there  into  a  pro- 
duction good,  in  this  case  flour,  and  the  fashioner  of  the 
latter  into  a  consumption  good,  bread.    We  have  as  repre- 


52  BANKING   THEORY 

sentatives  of  the  successive  hierarchy  farmer,  miller  and 
baker.  To  attain  completeness,  we  may  add  a  fourth  stage 
typified  by  the  consumer.  The  goods  produced  then  circu- 
late between  the  stages,  the  raw  material  passing  successively 
through  the  intermediate  stages,  and  acquiring  therein  in  this 
case  a  change  of  form  until  it  finally  reaches  the  ultimate 
consumer.5  But  there  is  also  a  change  to  be  noted  in  the  con- 
nection between  banking  system  and  industry.  The  single 
outlet  from,  as  well  as  the  single  inlet  to,  the  former  re- 
solves itself  into  several ;  in  short,  we  have  a  pair  for  each  of 
the  intermediate  stages  in  the  process.6  The  inflow  from 
the  banking  reservoir  through  the  system  of  inflow  pipes, 
as  we  may  for  the  sake  of  convenience  designate  them,  is 
intermittent  or  regular  according  as  the  requirements  of 
the  pool  are  small  or  great.  The  banking  system  in  effect 
controls  the  valves  regulating  the  inflow,  its  action  in  regard 
thereto  automatically  regulating  the  stream  through  the 
corresponding  system  of  inflow  pipes.7 

5  The  figure  also  covers  the  case  of  commodities  such  as 
machinery  which  in  their  finished  form  are  not  direct  consump- 
tion goods.  The  final  stage  here  represents  the  enterprise  for 
whom  they  function.  Again,  the  case  of  durable  consumption 
goods  controlled  by  one  individual,  which  yield  a  flow  of  service 
to  others  as  the  possessor  wills,  presents  no  difficulty,  likewise 
the  inclusion  of  stages  in  which  merely  time  and  place  utilities 
are  created.  The  figure  is  comprehensive  enough  to  include 
them  all. 

6Later  in  the  chapter,  as  well  as  in  Ch.  V,  we  shall  con- 
sider whether  it  is  necessary  to  add  a  pair  also  for  both  initial 
and  final  stages. 

7  Were  we  so  minded,  we  could  employ  in  this  connection  the 
mechanical  analogy  so  elaborately  worked  out  by  Irving  Fisher 
in  his  Mathematical  Investigations  in  the  Theory  of  Value  and 
Prices,  Transactions,  Connecticut  Academy  of  Arts  and  Sciences, 
Vol.  IX,  1894,  pp.  1-124.  The  figure  as  we  have  thus  crudely 
given  it  would  represent  the  top  view  of  a  series  of  cisterns  with 
movable  side  walls  and  bottoms. 


COMMERCIAL   BANKING  53 

2.  The  fund  of  capital  employed  in  the  process  is,  how- 
ever, not  an  independent  variable,  but  rather  a  dependent 
one.  While  outflow  from  the  reservoir  mathematically 
speaking  is  a  function  of  inflow,  the  fund  is  itself  a  func- 
tion of  other  variables.  The  banking  system,  while  it  holds 
the  fund,  does  not  in  point  of  fact  have  the  title  b  thereto 
vested  in  it ;  it  is  merely  a  trustee,  its  service  being  confined 
to  the  administration  of  the  fund.  It  is  merely  an  inter- 
mediary in  the  supply  of  capital.  The  pool  with  its  cease- 
less inflow  and  outflow  itself  varies  in  size  at  different  peri- 
ods. It  provides  merely  the  upper  level  of  the  analysis. 
There  is  a  lower  level  as  well.  The  source  of  available 
accumulations  on  the  lower  level  is  four-fold ;  in  addition  to 
the  deposits  of  the  industrial  community,  there  are  the  de- 
posits of  individuals,  both  temporary  surpluses  and  the 
permanent  accumulations  of  capitalists,  and  the  capital 
stock  and  surplus  of  the  banks  themselves.  The  amount 
of  accumulations  on  the  lower  level  determines  the  amount 
of  the  funds  which  may  be  employed  on  the  upper  level. 
Using  the  analogy  employed  by  J.  B.  Clark  in  another  con- 
nection, we  may  compare  the  first  to  the  waterfall,  the  sec- 
ond to  the  particles  of  water  continually  passing  through 
it.  But  the  analogy  is  again  inexact.  On  both  levels  there 
is  a  ceaseless  ebb  and  flow.  Into  the  pool  of  the  upper  level 
flow  the  sums  which  are  loaned,  while  out  of  it  and  into 
the  reservoir,  other  things  being  equal,  flow  the  sums  which 
represent  the  repayments  of  loans  previously  made ;  into  the 
fund  on  the  lower  level,  which  is  to  be  set  against  the  fund 
on  the  upper  level,  flow  the  current  funds  of  society — in 
the  main,  the  pecuniary  representations  of  the  contributions 
of  the  business  enterprise — while  out  of  it  flow  these  funds 
as  the  claims  on  society  which  they  represent  realize  them- 

8  Actually  as  distinguished  from  legally.  This  will  be  readily 
seen  from  a  consideration  of  bank  statements. 


54  BANKING   THEORY 

selves  in  definite  form,  such  as  the  purchase  of  raw  mate- 
rials, or  the  increment  in  the  value  of  a  commodity  due  to 
the  application  of  labor.  Though  the  fund  on  the  upper 
level  is  limited  by  the  fund  on  the  lower  level,  the  several 
currents  in  each  are  not  comparable  except  in  the  totality  of 
their  effects  upon  each  level.  Thus  loan  account  and  de- 
posit account  run  in  parallel  columns. 

In  connection  with  the  deposit  account,  the  current  funds 
of  society,  the  banking  system  acts  as  the  bookkeeper  for 
society.9  As  it  is  directed,  it  transfers  claims  among  the 
constituent  business  enterprises,  crediting  one  enterprise 
and  debiting  another.  It  credits  one  enterprise  for  a  con- 
tribution made  to  the  social  product,  cancels  its  credit  as 
it  fixes  the  claim  in  a  definite  good  or  service,  and  debits 
another  for  goods  or  services  procured  in  excess  of  past 
contributions  which  it  has  not  fixed  in  definite  form,  its 
debits  being  offset  as  it  makes  its  contributions.  In  other 
words,  there  is  occurring  a  species  of  social  clearing  of 
current  debits  and  credits  of  the  several  constituent  busi- 
ness enterprises.  In  connection  with  this  process — in  the 
administration  of  these  current  funds  of  society — the  com- 
mercial banking  system  is  performing  its  other  outstanding 
function.  In  addition  to  its  action  as  intermediary  in  the 
supply  of  capital,  in  gathering  and  administering  this  capital 
commercial  banking  is  functioning  in  a  peculiar  manner. 
The  process  which  it  employs  is  at  once  more  profound  and 
more  remarkable  than  in  the  case  of  investment  banking 
except  the  form  of  investment  banking  in  which  the  com- 
mercial banking  principle  is  employed.    It  acts  as  the  clear- 

9  It  will  be  observed  that  in  the  discussion  in  the  text,  as 
largely  also  in  the  first  two  chapters,  abstraction  has  been  made 
from  the  role  which  may  be  played  by  the  individual,  in  view  of 
its  subsidiary  character,  in  order  to  bring  out  sharply  the  more 
fundamental  aspects.  Compare  Ch.  II,  Section  5;  Ch.  V,  Sec- 
tion 3  and  Ch.  VI,  Section  1. 


COMMERCIAL   BANKING  55 

ing  agent  for  society.     Differently  phrased,  there  is  here 
coalescence  of  capital  supply  and  currency  system. 

3.  We  see  then  that  commercial  banking  may  be  consid- 
ered as  the  center  of  the  modern  commercial  credit  system, 
and  in  a  two-fold  sense.  In  its  loan  operations  it  extends 
credit,  in  its  deposit  operations  it  is  the  recipient  of  credit. 
With  the  development  of  commercial  banking  and  the  per- 
formance by  it  of  its  special  function  to  a  greater  and 
greater  degree,  there  is  a  tendency  to  have  it  concentrate 
credit  granting  in  its  hands,  either  through  "checking"  the 
credit  extended  in  first  instance  by  the  individual  enterprise 
or  by  itself  measuring  the  buyer's  credit  without  prior  judg- 
ment by  the  seller.  The  important  consequences  resulting 
herefrom  will  be  indicated  later.10  On  the  other  hand,  in  its 
action  as  bookkeeper  for  society  with  respect  to  society's 
current  funds,  commercial  banking  is  the  recipient  of  credit. 
While  banking  credit  is  basically  the  same  as  other  credit, 
and  the  early  charters  stress  the  privilege  which  was  con- 
ferred of  borrowing  from  the  public  by  means  of  its  bills 
or  notes,  in  the  historical  evolution  which  has  taken  place, 
banking  as  recipient  of  credit  has  become,  sharply  differ- 
entiated from  other  recipients  of  credit.  The  significant 
thing  is  not  the  fact  that  it  is  recipient  of  credit,  but  the 
peculiar  relation  in  which  it  stands  to  society  by  virtue  of 
this  fact.11  It  may  be  noted,  too,  that  in  the  deposit  system 
credit  on  open  book  account,  ordinarily  considered  a  low 
form  of  credit,  prevails,  although  the  fact  should  not  be 
overlooked  that  in  this  case  the  borrower  himself  keeps  the 
record. 

10Cf.  Ch.  VII,  Section  1.  It  will  be  seen  there  that  the 
statement  in  the  text  applies  to  investment  banking  also. 

11  For  an  analysis  of  points  of  similarity  and  difference,  com- 
pare Moulton,  Commercial  Banking  and  Capital  Formation,  I, 
Journal  of  Political  Economy,  Vol.  XXVI,  1918,  pp.  504-5. 


56  BANKING   THEORY 

It  is  interesting  to  observe  the  similarity  which  the  action 
of  commercial  banking  as  bookkeeper,  in  crediting  an  enter- 
prise when  it  has  made  a  contribution  to  the  social  product 
through  the  transfer  of  a  good  or  the  rendering  of  a  service, 
and  canceling  this  credit  as  the  claim  is  fixed  in  definite 
form  through  the  purchase  of  another  good  or  the  receipt  of 
a  service,  bears  to  certain  features  of  various  socialistic 
currency  and  banking  schemes  which  have  been  proposed. 
Proudhon's  exchange  bank  project  may  be  mentioned  as  a 
case  in  point,  as  well  as  the  several  more  or  less  related 
types  which  have  been  suggested,  in  particular  Solvay's 
plan  of  "social  accounting."12  The  banking  system  in  the 
present  order  of  course  does  not  directly  receive  from  and 
credit  the  worker  for  the  contribution  which  he  makes,  as 
the  schemes  of  Owen,  Mazel  and  others  require ;  in  society 
as  at  present  organized,  the  extent  of  his  contribution  is 
measured  in  first  instance  by  the  entrepreneur,  while  the  test 
of  contribution  to  the  social  product  lies  solely  in  the  will- 
ingness of  another  to  receive  the  good  or  service.  The 
banking  system  is  essentially  purely  an  intermediary  in  the 
process,  arranging  the  debit  and  credit  account  as  directed 
by  the  factors  which  control  the  situation.  Abstracting 
from  their  other,  and  in  some  respects  more  important 
phases,  when  regarded  from  this  one  point  of  view,  the 
plans  are  all  seen  to  embody  proposals  for  the  improvement 
of  the  technical  methods  by  which  the  banking  system  per- 
forms its  bookkeeping  function.13    In  performing  this  func- 

12  For  a  convenient  discussion  of  these  doctrines  within  small 
compass,  cf.  Gide  and  Rist,  A  History  of  Economic  Doctrines, 
etc.    Translation  by  R.  Richards,  Boston  [1915],  pp.  307-20. 

13  The  argument  that  this  function  is  performed  no  less  by 
every  currency  system  may  be  dismissed  with  a  reference  to  the 
fact  that  the  central  problem  in  the  plans  noted  concerns  the 
issue  of  the  same  in  exchange  for  values  created.     In  the  case 


COMMERCIAL   BANKING  57 

tion,  it  plays  what  is  an  integral  part  in  all  the  various  plans 
just  mentioned. 

It  is  a  far  cry  from  the  exposition  given  of  this  process 
of  credit  and  debit  for  contributions  made  and  fixed,  to  the 
following  statement  of  Hobson:14  "The  perfection  of  this 
process  would  be  a  business  world  in  which  every  piece  of 
wealth,  land,  building,  crops,  stock,  machinery,  materials 
and  goods  in  various  stages  of  production,  carried  with  it 
a  credit-note  representing  its  present  value,  which  could 
be  used  when  it  was  wanted."  The  absurdity  of  the  state- 
ment is  patent.  It  is  forgotten  that  currency  acts  purely  in 
an  intermediary  capacity,  to  enable  the  transfer  of  goods  or 
services,  as  we  have  indicated  above.15  It  is  required  only 
when  contributions  are  made  without  equivalent  return 
being  received.  As  soon  as  counter  flow  of  goods  or  ser- 
vices occurs,  the  need  for  currency  passes.  In  short,  as 
will  be  indicated  below,18  a  process  of  actual  offset  and  can- 
cellation of  claims  takes  place.  The  amount  of  representa- 
tives then  should  be  confined  to  the  amount  of  goods 
actually  passing  in  exchange  in  the  economic  process.     In 

of  the  employment  of  the  printing  press  by  a  State  to  raise  funds 
for  its  needs,  while  the  State  when  it  gives  the  currency  so 
created  to  enterprises  in  return  for  the  transfer  of  goods  to  itself 
technically  credits  them  for  contributions  made,  in  point  of  fact 
it  by  no  means  considers  the  measurement  of  the  true  value  on 
the  basis  of  the  existing  price  level  of  the  contribution  so  made. 
As  will  be  apparent  in  the  following  chapter,  the  banking  sys- 
tem on  the  other  hand  is  vitally  concerned  with  such  measure- 
ment through  its  creation  of  deposit  credits  in  the  loan  opera- 
tion. 

"Gold,  Prices  and  Wages,  London,  [1913],  p.  78. 

15  It  is  obvious  also  that  an  unrealized  claim  for  a  personal 
service  rendered,  as,  e.g.,  by  a  theatrical  company,  is  just  as  valid 
as  one  for  the  labor  of  carpenters,  yet  the  material  form  of  the 
first  is  gone  forever. 

16Cf.  Section  5. 


58 


BANKING   THEORY 


a  static  society  this  will  be  readily  apparent,  and  the  fact  that 
under  actual  dynamic  conditions  there  is  an  ever-moving 
margin  of  claims  which  are  unrealized,  should  not  be  per- 
mitted to  obscure  the  fundamental  features.  It  may  be  re- 
marked that  to  Hobson,  banking  is  essentially  a  means  of 
coining  current  wealth  into  purchasing  power,17  and  the 
above  sketch  gives  the  doctrinal  genealogy  of  this  phase  of 
the  pawnshop  conception  of  banking. 

4.  The  current  funds  above  referred  to  represent  in  the 
main  the  circulating  capital  of  society.  Not  only  do  the 
various  business  enterprises  practically  provide  the  bor- 
rowers, but  the  major  part  of  the  existing  volume  of  un- 
realized claims  is  held  by  them.  Through  the  institution 
of  commercial  banking  the  individual  business  enterprise 
contributes  its  surplus  and  obtains  its  deficit.  This  means 
in  last  resort  merely  that,  on  the  one  hand,  the  realizing  of 
previously  unrealized  claims  is  foregone  temporarily  by 
certain  business  enterprises,  while  others  are  enabled  to 
realize  the  claims  temporarily,  passing  on  at  the  close  of 
their  production  period  the  goods  in  which  their  claims  had 
been  realized,  and  thus  liquidating  the  loan  obtained.  Thus 
the  commercial  banking  system  combines  and  coordinates 
the  sporadic  potential  lending  or  sporadic  waiting  18  of  busi- 
ness enterprises.  By  virtue  of  this  pooling,  the  commercial 
banking  system  is  enabled  to  direct  the  capital  to  places 
where  it  is  required.  Society  thus  is  enabled  to  function 
with  the  average  amount  of  capital  required,  instead  of 
being  under  the  necessity  of  having  the  maximum  amount 
required  by  all  of  the  individual  firms,  as  would  be  the  case 

17  The  view  is  also  held  by  Fisher,  Elementary  Principles  of 
Economics,  New  York,  1911,  p.  161,  who  states  that  "to  put  it 
crudely,  banking  is  a  device  for  coining  into  dollars  land,  stoves, 
and  other  wealth  not  otherwise  generally  exchangeable." 

18  The  phrase  is  adapted  from  Brown,  Principles  of  Commerce, 
New  York,  1917,  p.  32. 


COMMERCIAL   BANKING  59 

were  each  firm  to  hold  separately  the  capital  it  employed. 
Through  the  pooling,  we  have  social  control  and  distribu- 
tion of  the  social  circulating  capital. 

We  have  confined  our  attention  thus  far  almost  entirely 
to  the  principal  fund.  Were  this  the  sole  reservoir,  ulti- 
mate borrowers  and  lenders  would,  as  we  have  seen,  be  in 
the  aggregate  one  and  the  same  body  of  persons,  and  it  is 
basically  the  function  of  commercial  banking  to  effect  co- 
operation of  this  character  between  business  enterprises. 
Theoretically  it  would  be  possible  in  a  static  society  for  the 
banking  system  to  function  merely  with  this  one  fund.  In 
actual  contemporary  society,  however,  the  case  is  not  so 
simple.  We  have  three  additional  sources  whence  funds 
are  derived.  These  are  deposits  of  individuals,  both  tem- 
porary surpluses  and  permanent  accumulations  of  capital- 
ists, and  the  capital  and  surplus  of  the  banking  system  itself, 
which  latter  in  point  of  actual  fact  exists  primarily  as  a 
guaranty  fund.19  The  funds  employed  in  the  process,  as 
we  have  seen,  all  function  through  the  banking  mechanism, 
which,  in  addition  to  the  the  fund  it  directly  contributes, 
determines  the  course  of  the  application  of  the  funds  con- 
tributed by  the  other  sources.  The  amount  contributed  by 
business  enterprises  and  part  of  that  contributed  by  indi- 
viduals is  due  chiefly  to  a  difference  in  time  between  the 
receipt  of  funds  and  the  necessity  for  paying  them  out.  Due 
largely  to  the  peculiar  function  of  this  fund,  the  commer- 
cial banking  system  meets  with  no  direct  competition  for  its 
use.     But  the  case  is  different  with  the  supply  originating 

19  The  last  two  sources,  in  the  use  of  which  commercial  bank- 
ing; functions  as  a  means  whereby  capital  is  transferred  from 
one  class  to  another,  are  merely  subsidiary.  Moreover,  as  offset 
in  some  measure  at  least  to  the  temporary  surpluses  of  indi- 
viduals are  their  temporary  deficits,  which  fact  should  not  be 
overlooked  in  the  analysis  of  the  upper  level.  Cf.  Ch.  V, 
Section  3. 


60  BANKING   THEORY 

from  the  third  source.  With  respect  to  his  current  funds, 
the  entire  range  of  economic  activity  beckons  to  the  capi- 
talist. His  choice  is  governed  by  considerations  of  ultimate 
safety,  immediate  realizability,  and  yield.  The  needs  of 
commerce  are  reflected  by  the  rate  of  interest,  and  through 
this  means  the  banking  system  may  direct  the  flow  into  the 
pool  of  commercial  financing  when  such  funds  are  re- 
quired in  this  sphere,  and  retain  them  for  the  period  re- 
quired. 

It  will  be  apparent  that  in  addition  to  the  circulating  capi- 
tal whose  application  is  effected  through  the  institution  of 
commercial  banking,  there  is  a  considerable  amount  of 
such  capital  which  is  directly  loaned  by  one  enterprise  to 
another  through  the  sale  of  goods  on  time,  or  which  is 
represented  by  direct  holding  of  commercial  paper  by  busi- 
ness enterprises.  Strictly,  then,  the  area  of  the  pool  of 
commercial  financing  should  be  broadened  to  include  also 
the  capital  so  applied.  In  the  supply  of  capital  in  this  broad- 
ened pool  of  commercial  financing,  however,  commercial 
banking  is  by  far  a  more  prominent  factor  than  is  the  in- 
dividual enterprise,  and  it  is  through  banking  that  coopera- 
tion in  the  application  of  the  social  circulating  capital  in  fact 
is  obtained.  Moreover,  the  commercal  banking  system  is 
the  most  prominent  factor  in  the  discount  market,  whereas 
the  investment  banking  system  by  no  means  occupies  an 
equal  position  in  the  security  market.  Hence  we  may  dis- 
miss the  pool  of  commercial  financing  with  this  brief  notice. 
In  contrast  to  the  situation  which  prevails  with  respect  to 
investment  banking,  for  an  understanding  of  the  institution 
of  commercial  banking,  detailed  examination  of  the  entire 
pool  is  not  required. 

5.  We  turn  now  to  a  consideration  of  the  manner  in 
which  the  transfer  of  capital  analyzed  above  is  effected. 
Otherwise  phrased,  we  consider  the  relation  between  the 


COMMERCIAL   BANKING  61 

two  levels  of  the  analysis  previously  indicated — between 
"loan  fund'  and  "deposit  fund."  Considering  for  illustra- 
tion purposes  a  loan  on  straight  single  name  paper,  the  loan 
involves  merely  in  first  instance  crediting  the  borrower  on 
the  books.  But  as  long  as  the  deposit  so  created  is  not 
employed,  i.  e.,  transferred  to  another,  it  is  of  little  import- 
ance. The  borrower,  however,  will  desire  actively  to  em- 
ploy the  funds  he  has  procured,  and  accordingly  will  for 
instance  purchase  goods  therewith  for  use  in  his  operations. 
In  payment  for  the  goods  he  tenders  a  check  to  the  seller, 
to  whom  the  credit  on  the  books  of  the  bank 20  is  then 
transferred.  But  in  accepting  the  deposit  credit  the  seller  in 
effect  supplies  the  capital  involved  in  the  financing  of  the 
transaction  through  the  foregoing  of  the  conversion  of  the 
claim  he  secures  for  the  good  which  he  has  contributed  to 
the  social  product.21  In  other  words,  the  seller  places  part 
of  his  circulating  capital  temporarily  at  the  buyer's  disposal. 
He  contributes  this  capital  for  the  financing  process  until 
he  calls  upon  the  bank,  either  withdrawing  the  deposit,  or 
transferring  it  to  another  enterprise,  in  which  latter  case 
the  enterprise  to  which  it  is  transferred  supplies  the  capi- 
tal. Through  the  fact  that  deposit  currency  has  a  high  ra- 
pidity of  circulation,  the  fact  that  the  holder  of  a  deposit 
credit  is  in  exactly  the  same  position  as  the  holder  of  a 
bank  note  is  often  lost  sight  of.  Banking  does  not  really 
effect  any  loan  of  capital  until  the  borrower  is  able  to  intro- 
duce to  it  an  enterprise  willing  to  act  as  the  real  lender. 
Only  when  the  enterprise  really  "makes"  its  deposit  by 
accepting  the  latter  in  exchange  for  its  goods,  and  thus 

20  Assuming  for  the  sake  of  simplicity  that  both  buyer  and 
seller  use  the  same  banker.  No  additional  theoretic  principles 
would  emerge  in  passing  to  more  complex  cases. 

21  In  effect,  then,  banking  releases  the  seller's  capital  to  him 
only  when  he  calls  upon  it. 


62  BANKING   THEORY 

swells  the  available  fund  of  capital,  is  capital  actually  sup- 
plied to  the  borrower.  With  the  transfer  of  the  deposit 
credits  to  other  enterprises,  especially  with  the  splitting  up 
of  the  sum  into  various  parts  through  the  drawing  of  a 
number  of  checks  against  it,  the  exact  identification  of  de- 
posit credits  with  the  loan  connected  therewith  becomes 
impossible.22  The  outlines  of  the  former  are  soon  blurred 
and  shortly  completely  obliterated.  The  particular  deposit 
becomes  merely  one  of  the  vast  numbers  which  together 
make  up  the  fund  of  capital  which  has  been  loaned  by  the 
institution  of  banking.  While  it  is  true  that  the  constituent 
parts  of  the  "loan  fund"  change,  the  constituent  elements 
of  the  "deposit  fund"  change  far  more  rapidly.  There  is 
a  ceaseless  flow  into  the  "deposit  fund,"  and  a  ceaseless 
outflow  as  the  elements  are  converted  from  claims  upon  the 
social  product  as  a  whole  into  titles  to  particular  parts 
thereof.  The  order  in  time  between  reception  of  deposits 
and  making  of  loans  as  regards  any  one  transaction  is  then 
seen  to  be  inverted.  The  loan  is  made,  and  simultaneously 
the  deposit  secured.  While  this  is  true  with  respect  to  the 
individual  transaction,  when  viewed  in  the  large  we  perceive 
both  loan  fund  and  deposit  fund.  Both  truly  exist,  though 
their  constituent  elements  change.  Our  more  detailed  an- 
alysis has  merely  shown  the  more  specific  connection  be- 
tween particular  loan  and  particular  deposit  at  the  com- 
mencement of  the  process. 

Nor  does  the  fact  that  loans  are  usually  repaid  in  claims 
on  the  bank  vitiate  the  above  analysis.  It  is  merely  a 
demonstration  of  the  check  exercised  by  the  lower  upon  the 

22  Deposits  by  business  enterprises  thus  perform  their  function 
through  supplying  capital  against  existing  loans.  Rather  is  it 
true  that  deposits  support  loans,  than,  as  Taylor,  The  Credit 
System,  New  York,  1913,  p.  57,  says,  that  deposits  are  sustained 
by  continually  substituted  new  promises. 


COMMERCIAL   BANKING  63 

upper  level.23  At  the  same  time  that  repayment  is  made, 
a  depositor  chooses  to  convert  his  general  claim  into  a  spe- 
cific title  to  goods,  in  this  case  the  contribution  of  the  bor- 
rower to  the  social  product.  The  depositor-purchaser  re- 
linquishes his  general  claim  upon  society,  which  the  bor- 
rower then  turns  over  to  the  banking  system  to  offset  the 
loan  which  he  had  obtained  from,  or,  more  accurately 
phrased,  through  the  latter.  This  claim  the  buyer  had  ob- 
tained in  exchange  for  a  contribution  which  he  had  made 
to  the  social  product.24  In  return  for  the  good  which  had 
flowed  from  him  at  that  time,  another  good  now  flows  to 
him.  The  claim  serves  as  a  medium  of  exchange  whereby 
he  parts  with  one  good  and  obtains  another;  the  claim  is 
created  in  first  instance  merely  to  transfer  the  good.  It  is 
obvious  that  when  the  circle  is  completed,  and  counter  flow 
has  offset  original  flow,  the  claim  created  to  represent  his 
original  contribution  has  performed  its  function.  At  the 
same  time,  the  loan  which,  together  with  the  deposit  credit, 
enabled  the  original  transfer  of  the  good,  likewise  has  per- 
formed its  function.  Cancellation  of  both  then  occurs  in 
the  manner  indicated.  An  equal  shrinkage  occurs  in  both 
loan  fund  and  deposit  fund.  In  the  absence  of  exact  iden- 
tification throughout  the  course  of  its  life  history  of  deposit 
credit  and  the  loan  which  it  originally  represented,  the  re- 
payment of  the  loan  serves  merely  to  effect  the  cancellation 
of  an  amount  of  deposit  credits  equivalent  in  value  thereto. 
Thus  the  volume  of  deposit  credits  in  existence  varies  with 
the  amount  of  unrealized  or  unfixed  claims  upon  society 

23  On  the  entire  question  of  cancellation,  cf.  Taylor,  op.  cit., 
Ch.  III. 

24  For  the  sake  of  simplicity,  we  abstract  from  the  case  in 
which  a  loan  had  been  made  to  the  purchasing  enterprise.  No 
additional  theoretic  principles  emerge  in  passing  to  the  more 
complex  case. 


64  BANKING   THEORY 

which  are  held,  and  in  satisfaction  of  which  goods  are  still 
to  be  passed  or  services  rendered  by  those  who  obtained  the 
goods  or  received  the  services  contributed  by  the  first 
group.25  This  is  in  rudimentary  form  what  is  implied  by 
the  conventional  conception  of  an  elastic  currency,  fluctuat- 
ing in  volume  in  response  to  "the  needs  of  trade." 

It  must  not  be  forgotten  that  in  the  above  analysis  the 
borrower  is  typified  almost  entirely  by  the  business  enter- 
prise, and  that  the  good  which  is  the  object  of  exchange 
represents  to  the  enterprise  which  purchases  the  same  part 
of  its  industrially  circulating  capital.26  The  pecuniary  claim 
granted  to  the  enterprise  borrowing  upon  its  single  name 
paper  is  converted  into  goods  for  passive  use  in  its  pro- 
ductive process,  and  the  loan  practically  resolves  itself  into 
mediation  at  the  outset  between  the  buyer-borrower  and  the 
seller  of  the  goods.  Other  enterprises  by  foregoing  the  use 
of  the  claims  on  society  which  they  hold — in  other  words, 
part  of  their  pecuniary  circulating  capital — enable  it  to  ob- 
tain the  industrially  circulating  capital  it  requires.27    When 

26  We  see,  then,  as  Laughlin  indicates,  that  claims  on  society 
are  liquidated  in  last  analysis  by  goods  alone.  Principles  of 
Money,  New  York,  1903,  pp.  77-78.  We  include  also  services. 
These  in  general  however  realize  themselves  in  the  additional 
values  of  goods,  and  offer  a  distinct  category  only  in  the  case  of 
consumptive  services,  such  as  those  rendered  in  connection  with 
the  theatre,  which  are  negligible  for  our  present  purpose. 

26  To  employ  Wagner's  terms,  although  we  do  not  express 
exact  agreement  with  the  precise  content  which  he  assigns  to 
them,  we  must  not  be  misled  by  the  previous  discussion  of  the 
cancellation  process  to  concentrate  our  attention  upon  Konsu- 
mentcngeld,  but  rather  remember  that  it  is  Produzentengeld  to 
which  our  attention  must  be  directed.  Cf.  Theoretische 
Sozialokonomik,  Zweite  Abteilung,  Zweiter  Band,  Leipzig,  1909, 
p.  158. 

27  The  bookkeeping  function  is  then  primarily  concerned  with 
the  debit  and  credit  accounts  of  business  enterprises. 


COMMERCIAL   BANKING  65 

the  enterprise  passes  on  the  good  to  another  and  receives 
payment,  the  claim  so  obtained  offsets  the  loan  previously 
made,  and  both  loan  and  deposit  credit  equal  in  value  to 
that  given  to  the  enterprise  which  originally  relinquished 
the  good,  are  canceled.  Commercial  banking  thus  directs 
the  abstinence  required  largely  on  the  part  of  other  enter- 
prises. Considering  society  as  a  whole,  by  this  means  it 
effects  a  pooling  of  the  circulating  capital  held  by  society. 
Viewing  the  real,  as  distinguished  from  the  pecuniary  level 
of  the  analysis,  through  its  action  it  enables  the  passage  of 
goods  through  the  several  stages  in  the  economic  process 
from  original  producer  to  ultimate  consumer,  standing  thus 
in  a  direct  relation  to  the  process. 

6.  It  will  be  opportune  at  this  point  to  consider  briefly 
the  relation  of  the  doctrines  here  advanced  to  those  of 
Veblen28  and  Davenport29  on  the  one  hand,  and  MacLeod30 
on  the  other  hand.  The  old  controversy  as  to  whether 
credit  per  se  is  capital  may  happily  be  accorded  an  honor- 
able burial.  MacL,eod  argues  that  it  is,  and  Davenport 
modifies  the  position  so  as  to  include  merely  capital  from 
the  private  acquisitive  as  distinguished  from  the  social 
point  of  view.  In  any  event,  the  old  classical  doctrine  of 
Ricardo,  which  has  done  valiant  service  in  the  suppression 
of   the   gross   heresy,    will   now   generally   be   conceded.31 

28Theory  of  Business  Enterprise,  New  York,  1915,  Ch.  V. 
The  Use  of  Loan  Credit. 

29Economics  of  Enterprise,  New  York,  1916,  Ch.  XVIL 
Money,  Credit  and  Banking. 

30Theory  of  Credit,  2d  Ed.,  Vol.  I,  London,  1893,  Chs.  Ill 
and  IV. 

31  McCulloch,  Principles  of  Political  Economy,  Edinburgh  and 
London,  1843,  p.  124.  Selection  reprinted  in  Moulton  (editor), 
Principles  of  Money  and  Banking,  Chicago,  1916,  Part  II,  pp. 
26-28.  Cf.  the  criticism  of  MacLeod  in  Knies,  Der  Credit,  Erste 
Halfte,  Berlin,  1876,  pp.  66-95;  also  v.  Komorzynski,  Die  Nation- 
alokonomische  Lehre  vom  Credit,  Innsbruck,  1903,  pp.  355-384. 


66  BANKING   THEORY 

Credit  does  not  increase  the  material  equipment  of  society. 
This,  however,  is  not  the  real  point  at  issue  between  the 
view  set  forth  in  this  work  and  the  above  writers.  Daven- 
port's conception  of  banking  as  interposing  itself  as  buffer 
between  buyer  and  seller  is  correct,  but  insufficient.  Credit 
is  merely  the  means  of  effecting  a  loan  of  capital.  The 
banking  system  in  effect  secures  control  of  a  certain  fund 
of  capital,  and  this  fund  it  loans  to  individuals.  Credit  is 
extended  to  borrowers,  and,  in  so  doing,  capital  is  loaned. 
This  capital  represents,  not  a  creation  of  new  capital,  but 
merely  a  transfer  of  control  over  certain  capital  already  in 
existence.  The  peculiarity  of  the  connection  between  capi- 
tal in  pecuniary  and  capital  in  industrial  form  must  not  be 
permitted  to  obscure  the  actual  existence  of  such  a  con- 
nection. 

There  is  in  addition  a  further  difference  in  the  point  of 
view  from  which  the  phenomenon  in  question  is  surveyed. 
Aside  from  his  interest  in  the  combination  of  commercial 
and  investment  operations  in  American  banking  practice  in 
the  past,  Veblen  is  concerned  primarily  with  the  other  half 
of  the  process  of  financing.  The  keenness  of  the  competi- 
tive struggle  in  modern  industrial  society  and  the  striving 
of  enterprises  for  increased  banking  accommodation  in  the 
race  for  larger  profits  is  uppermost  in  his  mind.  The  cen- 
tral problem  to  him  is  this :  Here  are  enterprises  appealing 
for  accommodation ;  how  much  are  they  to  be  loaned  ?  The 
problem  to  him  becomes  a  value  problem ;  his  interest  lies 

32  We  have  here  the  doctrinal  genealogy  of  another  of  the 
phases  of  the  pawnshop  conception  of  banking.  Veblen's  doc- 
trine has  its  roots  in  part  in  the  attempts  made  to  combine  per- 
manent capital  supply  and  currency — loans  to  enterprises  for 
fixed  capital  purposes,  loans  on  securities  or  actual  holding  of 
the  same,  providing  the  offset  against  demand  deposits.  Cf. 
Ch.  VI. 


COMMERCIAL   BANKING  67 

rather  in  capitalization  than  in  capital.32  But  the  technical 
methods  by  which  the  loan  is  effected  should  not  blind  us 
to  the  fundamental  elements.  Neither  whence  nor  whither 
may  be  neglected.  We,  on  the  other  hand,  have  considered 
rather  the  source  whence  the  funds  are  derived,  instead  of 
their  destination.  While  it  will  be  evident  from  the  above 
exposition  that  there  is  a  measure  of  justice  in  the  position 
maintained  by  Veblen,  it  will  be  equally  evident  that  the  doc- 
trine of  loan  credit  without  the  further  analysis  which  we 
have  made  is  both  misleading  and  unsound.  We  cannot 
say  with  the  enthusiastic  disciple,  "The  sky  is  the  limit." 
The  modern  credit  mechanism  is  wonderful  enough  in 
reality  without  attributing  to  it  magical  powers  which  it 
does  not  possess.  Among  its  belongings  there  is  no  Allad- 
in's  lamp. 

In  brief,  it  is  a  mistake  to  consider  the  analysis  made  by 
Veblen  as  a  "general  purpose"  analysis.  As  in  statistical,  so 
in  economic  analysis  there  must  be  an  adaptation  of  means 
to  ends,  the  methods  employed  varying  according  to  the  goal 
to  be  reached.  This  is  specifically  recognized  by  Veblen  in 
the  passage  where  he  brushes  aside  what  is  basically  the 
analysis  given  in  the  preceding  paragraph  as  irrelevant  to 
his  problem.  Yet  for  an  understanding  of  the  role  played  by 
the  institution  of  banking  in  modern  economic  society  this 
analysis  is  vital. 


CHAPTER  IV 

SOME  FURTHER   ASPECTS   OF   COMMERCIAL   BANKING 

1.  In  connection  with  its  loan  operations,  commercial 
banking  x  performs  the  so-called  "guaranty  function."  This 
has  been  selected  by  certain  writers  as  the  central  factor  of 
the  institution  of  banking.  Among  the  foremost  exponents 
of  this  view  is  Willis,  who  has  expressed  the  conception  as 
follows : 2 

The   "single   dominant   idea   or   function" 
"is   that"      .      .      .      "of   guaranteeing   the   limited   or 
individual  credit  of  each  individual  by  accepting  it  and 
substituting   in    lieu   thereof   the   bank's    own    credit." 
"The  bank  thus  appears  as  an  institution  for 
the  study  of  credit  and  for  guaranteeing  its  judgment 
on  that  subject."     .      .      .     "In  order  to  render  possi- 
ble the   commercial  transactions  of  the  present  day, 
what  is  needed   by  the   ordinary  trader     ...      is 
the  guarantee  of  some  recognized  and  known  institu- 
tion that  he  can,  upon  due  notice,  convert  the  wealth 
he  owns  into  money  or  its  equivalent." 
Moulton  has  criticized  the  above  passages,  holding  that  in 
the  operation  described  "the  bank  does  not  in  fact  guarantee 
that  X  will  pay  his  obligation  to  Y  at  maturity,  nor  does 
the  bank  agree  to  pay  X's  liability  for  him  at  the  end  of 
three  months.    The  bank  agrees  to  pay,  and  does  pay,  the 

aIn  the  present  chapter,  the  term  "banking"  again  refers,  un- 
less specifically  otherwise  mentioned,  to  commercial  banking. 
2  American  Banking,  Chicago,   1916,  pp.   3,  4,  6. 


FURTHER  ASPECTS  OF  COMMERCIAL  BANKING  69 

obligation  at  once."  3  The  relation  hereof  to  his  view  of  the 
distinctive  position  occupied  by  banking  credit  as  compared 
with  other  credit  is  readily  apparent.  This,  however,  is  by 
no  means  the  central  point ;  rather  does  it  concern  the  neces- 
sity which  exists  for  an  analysis  of  the  exact  meaning  of  the 
term  "guaranty."  Our  interest  lies  in  what  is  guaranteed, 
rather  than  in  how  the  guaranty  is  effected.  Willis  attempts 
an  explanation  in  the  latter  part  of  the  quotation.  His 
statement  is  unfortunate,  containing  as  it  does  a  definite 
statement  of  the  pawnshop  conception  of  banking.  In  es- 
sence, what  occurs  is  that  banking  underwrites  the  produc- 
tive operation  of  the  business  enterprise.  This  operation, 
as  we  shall  see,  the  business  enterprise  may  commence 
only  after  the  loan  is  made,  it  may  previously  have  started 
the  same,  or  again,  in  its  stage  of  the  economic  process  the 
purely  productive  as  contrasted  with  the  marketing  sub- 
stage  may  have  been  passed.  In  certain  of  these  cases, 
the  nominal,  though  not  the  real  borrower  changes.  In  any 
event,  however,  the  banking  system  agrees  to  bear  the  loss 
in  case  the  operation  be  not  carried  to  a  successful  conclu- 
sion ;  in  other  words,  in  case  a  misdirection  of  productive 
activity  occurs.  In  so  acting,  it  differs  basically  not  a  whit 
from  any  other  lender,  either  in  kind  (in  the  case  of  a  sale 
on  time)  or  in  purchasing  power.  Such  lenders,  however, 
merely  lose  permanently  to  the  extent  of  the  failure  of  the 
borrower  to  return  the  amount  of  the  same,  the  control  of 
the  purchasing  power  which  they  had  surrendered  tem- 
porarily. In  the  case  of  banking,  on  the  other  hand,  the 
purchasing  power  lent  is  represented  by  deposit  accounts. 
In  the  event  of  failure  to  repay  the  loan,  the  decrease  in 
the  loan  account  which  occurs  when  the  loan  is  written  off 
is  not  accompanied  by  a  corresponding  decrease  fn  the  de- 

3  Commercial  Banking  and  Capital   Formation,   I,  Journal  of 
Folitical  Economy,  Vol.  XXVI,  1918,  p.  506. 


70  BANKING   THEORY 

posit  account.  The  banking  system  is  then  under  the  neces- 
sity of  canceling  an  equivalent  amount  of  purchasing 
power,  or,  as  we  have  previously  phrased  it,  of  claims  on  the 
social  product.  To  do  this,  of  course,  will  require  a  supply 
of  such  claims  as  a  guaranty  fund  upon  which  to  draw, 
hence  the  need  of  capital  and  surplus  in  banking.  Viewed 
in  another  and  broader  light,  the  result  is  to  effect  an  ad- 
justment of  the  claims  held  by  society  to  the  value  of  the 
goods  available  to  liquidate  these  claims.  The  banking  sys- 
tem thus  guarantees  that  at  some  specified  future  date, 
namely,  when  the  loan  falls  due,  no  discrepancy  between  the 
claims  and  the  goods  in  existence  will  have  resulted  from 
the  operation  which  it  has  financed. 

It  is  evident  that  banking  looks  to  the  borrower's  future 
contribution  to  the  social  product,  and  that  the  loan  is  made 
in  view  of  that  contribution.  To  the  borrower,  then,  the 
loan  is  often  said  to  anticipate  the  future.  The  "bank  af- 
fords by  anticipation  the  present  use  of  future  funds."  Men 
enjoy  "a  share  of  subsisting  [commodities],  which  is  pro- 
portionate to  the  claim  [they]  have  upon  future  goods,"  to 
quote  Taylor.4  The  view  is  a  corollary  of  the  promissory 
note  system,5  and  regards  the  matter  from  the  borrower's 
point  of  view.  It  is  held  that  banking  enables  him  to  obtain 
the  present  value  of  his  future  contributions.6     The  state- 

4  Op.  cit.,  pp.  23,  29.  Thus  banking  appears  to  coin  future 
wealth  into  present  purchasing  power.  The  explanation  in  the 
text  gives  the  doctrinal  genealogy  of  this  particular  phase  of  the 
pawnshop   conception  of  banking. 

5  Cf.  Taylor's  frequent  references  to  the  note. 

8  It  may  appear  to  the  reader  that  Taylor's  position  possesses 
a  certain  validity  in  the  case  of  a  loan  made  to  a  seller  of  goods 
either  directly  or  on  the  basis  of  his  receivables.  For  a  discus- 
sion of  such  loans,  cf.  Section  2.  It  is  of  course  technically  true 
that  the  seller  who  has  his  capital  released,  insofar  as  he  did 
not  borrow  from  the  banking  system,  but  had  directly  foregone 
the  use  of  part  of  his  own  circulating  capital,  is  given  the  option 


FURTHER  ASPECTS  OF   COMMERCIAL  BANKING  71 

ment,  however,  is  misleading.  The  borrower  borrows  in 
order  to  buy.  Banking  thus  enables  him  to  obtain  the  goods 
which  he  will  pass  through  his  stage  in  the  economic  pro- 
cess, and  (or)  to  retain  them  for  the  period  during  which  he 
is  engaged  in  passing  them  thru  the  stage  in  question.  The 
loan  is  used  for  this  specific  purpose.  "Money"  to  the 
actual  borrower  by  no  means  performs  the  "bearer  of 
options"  function,  to  employ  Anderson's  phrase,7  or,  as 
previously  expressed  by  Wagner,8  serves  "as  a  means  of 
representation  of  capital  in  disposable  form  for  all  pur- 
poses." The  borrower  by  no  means  obtains  funds  which 
he  may  apply  for  purely  consumptive  purposes.  Instead, 
it  should  be  recognized  that  the  loan  merely  enables  him 
to  become  social  trustee  for  a  good  which  he  will  pass 
through  his  stage  in  the  process.  In  essence,  merely  a  loan 
of  certain  particular  goods  is  effected. 

Taylor's  doctrine  of  anticipation  of  the  future  has  as 
corollary  his  view  that  the  deposits  created  in  the  loan 
operations  represent  future  goods,  and  hence  that  "present 
goods  are  exchanged  by  means  of  future."  9  In  view  of  th*e 
above  analysis,  the  structure  falls  to  the  ground.  The  major 
part  of  "present"  goods  in  whose  exchange  banking  inter- 
venes are  in  the  intermediate  and  not  in  the  final  consump- 

of  applying  his  capital  prior  to  the  date  when  funds  are  actually 
due  him.    But  the  loan  in  point  of  actual  fact  is  made  to  a  buyer. 

7  Op.  cit.,  pp.  424  ff. 

8  Theoretische  Sozialokonomik,  Zweite  Abteilung,  Zweiter 
Band,  Leipzig,  1909,  p.  122.  The  doctrine  is  also  contained  in 
Menger,  in  the  article  cited  above. 

9  Op.  cit.,  title  page.  As  is  well  known,  anticipation  of  the 
future  had  been  ascribed  by  earlier  writers  to  the  institution  of 
credit,  rather  than  to  the  institution  of  banking.  The  doctrine  in 
this  form  would  appear  to  be  a  corollary  of  the  familiar  attempt 
to  define  credit  in  terms  of  an  exchange  in  which  the  contribu- 
tion by  one  of  the  parties  is  deferred.  Cf.  von  Komorzynski,  op. 
cit.,  pp.  384-403. 


72  BANKING   THEORY 

tion  stage.     These  intermediate  goods,   it  has  been  seen, 
change  hands  because  it  is  believed  by  the  banking  system 
that  the  buyer-borrower  will  successfully  pass  them  through 
his  stage  in  the  economic  process.    In  short,  present  as  con- 
trasted with  future  goods  refer  merely  to  the  same  goods 
in  two  different  stages   of   advancement.     Taylor's  state- 
ment then  is  more  accurately  phrased  as  follows :    Interme- 
diate goods  are  exchanged  by  reason  of  the  confidence  of 
the  banking  system  in  the  ability  of  the  buyer  to  successfully 
advance  them  in  the  economic  process.     It  should  also  be 
remarked  that  the  deposit  credit,  while  it  enables  buyer-bor- 
rower in  this  limited  sense  to  trade  on  the  future,  at  the 
same  time  represents  a  seller's  contribution.    Moreover,  the 
conditions  surrounding  the  loan  operation  are  such  as  to 
ensure  that  the  seller  makes  a  real  contribution,  or  to  verify 
the   fact   that   he  previously  has   made   one.     It  may   be 
urged  that  part  of  the  deposit  credits  so  created,  however, 
are  paid  as  wages  and  thus  enable  consumption  goods  to 
flow,  in  that  the  workers  to  whom  the  buyer-borrower  trans- 
fers the  same  expend  them  for  consumption  goods,  i.  e., 
the  means  of  their  subsistence.    The  amount,  however,  will 
be  but  by  far  the  smaller  part  of  such  loans.     This  raises 
the  further  problem  of  the  extent  of  the  pooling,  which  will 
be  treated  later.10 

2.  The  manner  in  which  banking  mediates  between 
buyer  and  seller  varies  according  to  the  type  of  loan — that 
is,  the  form  of  the  paper,  and  the  manner  in  which  this 
paper  finds  its  way  into  the  banking  system.  We  consider 
first  the  loan  for  which  a  commodity  is  given  as  collateral.11 

10  Ch.  V,  Section  3. 

"Cf.  Moulton,  Commercial  Banking  and  Capital  Formation, 
II,  Journal  of  Political  Economy,  Vol.  XXVI,  1918,  pp.  649  ff. 
Moulton  and  the  present  writer  disagree  over  the  term  "com- 
mercial banking."  which,  in  the  present  writer's  opinion,  is  con- 
cerned with  the  manner  in  which  cooperation  in  the  application 


FURTHER  ASPECTS  OF   COMMERCIAL  BANKING  73 

Such  loans  are  of  three  types,  although  the  exposition  which 
follows  applies  equally  to  each:    (1)  the  loan  upon  bill  of 
lading  collateral,  in  which  case  a  transaction  has  occurred, 
(2)    the   loan   upon   warehouse   receipts,    which   represent 
either  the  current  supply  of  raw  material  for  a  manufactur- 
ing enterprise,  or  a  staple  commodity  in  the  lower  stages, 
such  as  grain,  engaged  in  passing  through  the  market  from 
original  producer  to  manufacturing  consumer,  and  (3)  the 
loan  upon  a  finished  product,  either  to  manufacturer  or  dis- 
tributor, the  dffference  between  the  second  and  third  types 
consisting  in  large  part  in  the  degree  of  advancement  of  the 
good  in  the  economic  process.     Fundamentally,  banking  in 
the  case  of  such  loans  performs  its  mediatory  office  some 
time  after  the  underlying  transaction  has  occurred.     The 
average  circulating  capital  owned  by  the  business  enter- 
prise is  insufficient  to  bridge  both  the  production  and  the 
marketing  sub-stages  in  its  stage  in  the  economic  process, 
though  it  may  be  noted  that  the  production  sub-stage  may 
not  exist,  as  in  the  case  of  a  purely  mercantile  enterprise 
where  only  time  and  place  utilities  are  created.     The  loan 
may  be  made  either  at  the  commencement  or  close  of  the 
passage  of  the  good  through  the  stage.    The  relative  length 
of  time  for  which  the  enterprise  itself  carries  the  good,  as 
compared   with   the   length   of   the   stay   of   the   good   in 
the  stage,  varies  with  the  type  of  loan  and  the  industry  in 
question.    In  all  cases,  however,  the  enterprise  requires  the 
release  of  its  capital  in  order  to  engage  in  new  productive 
operations.    In  certain  cases,  such  as  the  marketing  of  the 
great  agricultural  staples,  because  of  the  risk  in  grading,  etc., 
it  is  essential  that  the  business  enterprise  possesses  sufficient 

of  the  social  circulating  capital  is  effected,  and  by  no  means  has 
as  a  corollary  the  recognition  merely  of  paper  specifically  related 
on  its  face  to  a  given  transaction.  It  carries  no  logical  implica- 
tion as  to  the  form  of  the  paper.    Cf.  also  Section  3. 


74  BANKING  THEORY 

capital  to  enable  it  to  bridge  the  initial  portion  of  the  stage ; 
in  other  parts  of  the  economic  process,  the  possession  of 
such  capital  may  be  entirely  optional.  Viewed  in  another 
way,  what  occurs  in  the  case  of  the  collateral  loan  is  that 
the  capital  of  the  individual  firm,  taken  in  conjunction  with 
its  production  period,  is  insufficient  for  the  volume  of  busi- 
ness done,  and  in  absence  of  greater  rapidity  of  turnover, 
additional  capital  must  be  borrowed.  It  will  be  observed  that 
this  statement  parallels  somewhat  closely  those  made  by  cer- 
tain writers  who  regard  banking  as  a  species  of  "friend  in 
need."  This,  however,  by  no  means  implies  entire  agree- 
ment with  the  view  that  a  major  field  for  banking  exists 
"where  a  market  is  absent  or  where  purchases  on  credit 
have  already  been  instituted  in  place  of  cash  payment,"  and 
thus  "the  circulating  capital  which  is  embodied  in  the  fin- 
ished products  of  a  single  stage  in  the  productive  process 
does  not  always  again  become  available  rapidly  enough  to 
ensure  an  uninterrupted  productive  process."12 

The  collateral  loan,  although  currently  so  conceived,13  thus 
by  no  means  represents  a  coining  of  present  wealth  into  pur- 
chasing power.  It  assists  in  the  passage  of  goods  through 
the  economic  process  just  as  truly  as  do  other  types  of  loan. 
In  the  case  of  a  loan  directly  tied  to  a  transaction,  the  seller 
is  credited  for  his  contribution,  while  the  buyer  obtains  pos- 
session of  the  good  which  he  is  to  pass  through  his  stage  in 
the  economic  process.     In  the  case  of  the  collateral  loan, 

12  Wagner,  Der  Kredit  und  das  Bankwesen,  Schonberg,  Hand- 
buch  der  Politischen  Oekonomie,  Vierte  Auflage,  Erster  Band, 
Tubingen,  1896,  p.  432.  Compare  also  the  following  statement  of 
Bisschop,  The  Rise  of  the  London  Money  Market,  1640-1826, 
London,  1910,  p.  247:  "A  bank's  assistance  is  generally  required 
in  the  final  stage  of  the  period  of  production." 

13  The  collateral  loan  thus  provides  another  source  in  a  study 
of  the  doctrinal  genealogy  of  the  pawnshop  conception  of 
banking. 


FURTHER  ASPECTS  OF   COMMERCIAL  BANKING  75 

an  enterprise  engaged  in  passing  through  its  stage 
of  the  economic  process  a  good  which  it  had  previously  pur- 
chased with  its  own  funds,  wishes  to  engage  in  additional 
operations.14  It  thereupon  applies  to  the  banking  system  for 
a  loan  upon  the  good  which  it  is  engaged  in  passing,  request- 
ing the  banking  system  to  mediate  between  it  and  the  enter- 
prise which  had  previously  sold  it  the  goods,  and  thus  release 
to  it  the  capital  which  it  had  previously  invested  in  the  goods 
in  question,  instead  of  requesting  the  mediation  of  the  bank- 
ing system  in  the  new  transaction  which  it  is  about  to  under- 
take. Aside  from  advantages  which  may  result  to  the  indi- 
vidual enterprise  from  this  procedure,  it  should  be  noted  also 
that  theoretically  the  collateral  loan  should  be  less  hazar- 
dous, inasmuch  as  banking  "checks"  the  credit  when  the 
good  has  already  partially  passed  through  the  stage  in  the 
economic  process.  The  objection  at  times  raised  to  the  col- 
lateral loan  as  contrasted  with  the  loan  made  directly  upon 
a  sale  is  based  upon  hesitation  to  assist  the  enterprise  which 
has  one  of  its  operations  unfinished  to  undertake  another. 
The  question  raised  is  however  entirely  one  of  the  demon- 
strated ability  of  the  enterprise  to  successfully  pass  the 
goods  through  its  stage  in  the  economic  process,  and  the 
ability  may  be  ascertained  by  reference  to  the  statement  and 
the  "credit  turnover"  there  shown,  as  well  as  to  the  character 
of  the  underlying  collateral.  Only  in  the  absence  of  regular 
flow  through  the  economic  process  of  the  goods  upon  which 
the  loan  is  based,  need  deleterious  effects  occur.  Two  cases 
wherein  this  may  occur  should  be  noted ;  first,  where  loans 
are  made  to  enable  the  holding  of  a  good,  such  as  cotton, 
beyond  the  customary  marketing  period,  in  order  to  prevent 
a  sacrifice,  in  which  event  a  confession  of  failure  to  success- 
fully pass  the  good  thru  the  stage  is  necessarily  involved,  and 

14  We  abstract  here  from  the  first  type  of  collateral  loan. 


76  BANKING   THEORY 

second,  in  the  case  of  loans  upon  fixed  assets  such  as  land.13 
In  these  cases,  especially  if  widespread,  there  occurs  the 
effect  upon  prices,  due  to  the  disproportion  between  the 
purchasing  power  created  and  the  goods  available  in  which 
to  fix  the  same,  which  is  commonly  attributed  to  this  type 
of  loan.16 

It  will  be  apparent  that  sharp  distinction  must  be  made 
between  real  and  nominal  borrower.  Banking  in  every  case 
mediates  between  buyer  and  seller.  The  real  borrower  in 
every  case  is  the  buyer,  who  is  engaged  in  passing  the  good 
thru  his  stage  in  the  economic  process.  The  underlying  sig- 
nificance of  banking,  its  relation  to  the  economic  process, 
and  its  operation,  must  not  be  obscured  by  the  uneven  dis- 
tribution in  relation  to  requirements  of  capital  holdings  be- 
tween various  enterprises.  Each  enterprise  does  not  own 
capital  sufficient  for  its  average  requirements.  Thus  we 
find  that  seller  carries  buyer  in  many  cases,  while  in  other 
cases  the  buyer  may  possess  capital  sufficient  for  his  maxi- 
mum needs,  employing  the  surplus  in  another  manner  during 
slack  periods.  It  is  essential  for  a  clear  understanding  of 
the  fundamental  aspects  to  consider  the  individual  purchas- 
ing enterprises  as  either  possessing  the  capital  required  for 
a  given  transaction,  or  else  obtaining  the  same  through  the 
banking  system,  but  not  from  the  seller. 


17 


15  For  a  discussion  of  such  loans,  cf.  Ch.  VI. 

16The  best  recent  illustration  is  afforded  by  German  war 
finance  and  the  instrumentalities  created  in  connection  therewith, 
such  as  the  Darlehnskassen.  Abstracting  from  the  question  of 
the  necessity  of  the  device  as  a  means  of  raising  funds  for  Gov- 
ernment, it  is  clearly  perceived  that  there  is  a  limit  within  which 
such  loans  may  be  made.  Cf.,  e.g.,  Laughlin,  Credit  of  the 
Nations,  New  York,  1918,  passim. 

17  This  will  serve  to  answer  the  objection  which  may  be  raised 
to  our  treatment  of  the  loan  on  bill  of  lading  collateral,  where 


FURTHER  ASPECTS  OF  COMMERCIAL  BANKING  77 

The  collateral  loan,  however,  is  by  no  means  the  sole  type 
in  which  the  banking  system  performs  its  mediatory  service 
some  time  after  the  underlying  transaction  has  occurred. 
In  practice  the  use  of  the  commodity  collateral  loan,  which  is 
dependent  in  considerable  measure  upon  the  prevalent  mar- 
ket organization,  is  confined  largely  to  the  lower  stages  in 
the  economic  process,  before  the  smaller  number  of  staple 
articles  have  become  differentiated — a  mass  of  the  former 
spread  out,  fan-shape,  into  a  multiplicity  of  smaller  amounts 
of  specialized  products.  In  either  earlier  or  later  stages,  the 
seller  on  time  may  have  his  capital  released  by  a  pledge  of 
the  receivables,  in  whatever  form — notes,  open  book  ac- 
counts or  trade  acceptances — representing  the  buyer's  obliga- 
tion, or  else  the  seller  may  borrow  directly  on  his  own  single 
name  paper.  In  the  first  case — the  loan  on  commodity  col- 
lateral— the  buyer,  in  the  second  case,  the  seller,  has  tem- 
porarily supplied  the  capital  required.  In  the  second  case, 
then,  there  is  not  the  hesitancy  which  occurs  in  the  first  case 
to  release  the  capital  involved  in  the  operation,  as  the  seller 
has  made  a  definite  contribution,  and  has  only  a  secondary 
interest  in  the  productive  operation  in  which  the  buyer  is 
engaged.  At  the  same  time,  however,  the  apparent  concen- 
tration of  the  interest  of  banking  in  making  the  loan  upon 
the  status  of  the  seller,  must  not  blind  us  to  the  fact  that  the 
ultimate  factor  in  liquidating  the  loan  operation  is  never- 
theless the  buyer,  and  the  operation  in  which  he  engages. 

3.  In  considering  the  case  in  which  the  seller  borrows 
directly  on  his  own  single  name  paper,  we  pass  from  paper 
directly  related  to  the  individual  transaction  to  paper  which 
is  referred  to  the  general  operations  of  the  individual  firm. 
For  the  purposes  of  the  present  discussion,  representative 

it  may  be  objected  that  the  loan  is  made  to  the  seller  on  such 
collateral,  whereas  in  point  of  fact  the  capital  is  supplied  for  a 
small  portion  of  the  buyer's  stage. 


78  BANKING   THEORY 

respectively  of  the  two  systems  may  be  considered  the  bill 
of  exchange  or  trade  acceptance  and  the  promissory  note. 
The  rise  of  the  latter  system  had  been  held  to  militate 
against  the  theory  of  commercial  banking  which  is  ex- 
pounded in  the  present  work.  But  the  view  that  the  recog- 
nition of  the  existence  of  a  distinct  institution  of  commercial 
banking  of  necessity  implies  a  situation  in  which  "the  bank 
is  merely  to  make  temporary  advances,  extending  each  indi- 
vidual loan  on  its  individual  merits,"18  is  entirely  fallacious. 
In  order  to  demonstrate  the  justice  of  our  position,  let  us 
consider  at  some  length  the  essential  features  of  the  two 
systems.  There  is  no  intrinsic  value  attaching  to  either  the 
promissory  note  or  trade  acceptance  as  such ;  for  the  present 
purpose  both  are  to  be  considered  merely  as  means  to  an  end, 
namely  the  satisfactory  performance  by  the  institution  of 
banking  of  its  peculiar  function.  Through  the  measure  of 
credit  thus  effected,  assurance  of  proper  direction  (in  the 
sense  of  antithesis  of  misdirection)  of  productive  activity  is 
to  be  obtained.  The  problem  is  a  minimal  one;  the  obtain- 
ing of  the  maximum  assurance  with  the  minimum  effort. 
The  two  types  of  paper  represent  rival  methods  of  attaining 
this  goal.  Briefly  characterized,  the  contrast  is  between  the 
technical  methods  of  tieing  the  paper  to  a  transaction  or 
series  of  transactions19  and  the  extension  of  "lines  of  credit." 
The  contrast  is  most  clearly  seen  by  reference  to  the 
accompanying  diagram,  which  represents  the  method  of 
financing  under  the  two  methods.  Where  the  paper  is  tied 
to  a  transaction,  banking  of  necessity  must  consider  each 

18  Moulton,  Commercial  Banking  and  Capital  Formation,  III, 
Journal  of  Political  Economy,  Vol.  XXVI,  1918,  p.  718.  Cf.  also 
pp.  645-6. 

19  In  the  event  that  a  single  acceptance  be  given  to  cover  a 
group  of  transactions,  as  has  been  suggested  in  connection  with 
retail  trade. 


FURTHER  ASPECTS   OF   COMMERCIAL  BANKING 


79 


TIE1NG 
TRANSACTION 


BANKING 

BANKING 

V_ 

_^_ 

y 

sale: 


*c 


PURCHASEJSIioSALE 

IN  ONE  STAGE"™  PROCESS 


PURCHASE 


X 

c 

N 

BANKING 

LINC- CREDIT 


individual  transaction.  The  line  of  credit  system  represents 
an  attempt  to  apply  the  economies  of  large-scale  operation. 
May  we  not  group  transactions,  and  pass  upon  an  entire 
series  at  once,  instead  of  upon  each  individually?  More 
than  this,  however,  may  we  not  make  use  of  the  fact  that 
in  the  economic  process  the  individual  enterprise  acts  both 
as  buyer  and  seller?  May  we  not  then  bring  together  a 
whole  series  of  transactions,  both  purchases  and  sales,  of 
the  individual  firm,  and  pass  upon  them  en  bloc?  This 
is  precisely  what  is  done.  By  this  means  equivalence  of  an 
entire  series  of  transactions  and  the  sum  total  of  paper 
created  therefrom  is  obtained,  rather  than  exact  identity  of 
each  separate  transaction  or  group  of  sellers'  transactions 
in  the  series  and  constituent  piece  or  pieces  of  paper.  In 
either  case,  banking  mediates  between  buyer  and  seller. 
Moreover,  in  case  the  loan  is  tied  to  a  transaction,  the  bank- 
ing system  must  look  likewise  to  the  buyer's  stage  in  the 
process  and  the  probable  success  of  the  productive  opera- 
tions in  which  he  engages — in  other  words,  to  the  sale  which 
occurs  at  the  close  of  his  production  period.  It  does  not, 
however,  have  as  a  central  problem  the  judgment  of  the 
totality  of  his  operations  and  the  consideration  of  the  inter- 
play of  his  purchases  and  sales  upon  his  general  standing, 
as  is  the  case  with  the  other  method.     It  should  be  noted 


80  BANKING   THEORY 

that  the  employment  of  the  line  of  credit  device  means  that 
estimation  must  be  made  of  the  series  of  operations  to  be 
undertaken  for  a  considerable  period  in  advance.  In  this 
connection,  the  fact  that  the  enterprise  has  been  successful 
in  similar  operations,  and  under  conditions  similar  to  those 
at  present  prevailing,  creates  a  presumption  in  its  favor  of 
ability  to  do  likewise  in  the  future.  This  is  the  kernel  of 
contemporary  practice  relative  to  credit  analysis.  Various 
auxiliary  safeguards  of  course  are  introduced,  such  as,  e.g., 
the  requirement  that  the  individual  enterprise  "clean  up"  its 
indebtedness  periodically.20 

The  promissory  note  finds  its  principal  use  in  connection 
with  the  cash-discount  system  of  commercial  payments, 
while  the  stronghold  of  the  trade  acceptance  lies  rather  in 
the  system  of  net  terms.  It  may  be  pointed  out  that  the  note 
system  throws  the  burden  of  credit  measurement  directly  on 
the  institution  of  banking,  while  the  acceptance  system,  on 
the  other  hand,  may  involve  a  prior  measurement  by  the 
seller  of  the  credit  of  the  buyer  in  addition  to  the  subsequent 
measurement  by  the  institution  of  banking.21  The  employ- 
ment of  the  banker's  acceptance  achieves  the  same  results. 
The  individual  bank  through  its  dispensation  of  the  capital 

20  It  should  be  remarked,  however,  that  the  chief  virtue  of  this 
device  lies  rather  in  the  proof  which  it  affords  of  the  character 
of  the  use  to  which  the  loan  has  been  put. 

21  As  is  well  known,  unanimity  of  opinion  by  no  means  exists 
as  to  the  relative  merits  of  the  two  methods,  or,  as  sometimes 
expressed,  when  viewing  the  matter  from  another  angle,  as  to 
the  proper  "location  of  the  financing."  It  is  interesting  to  ob- 
serve that  the  problem  was  touched  upon  by  Knies,  Der  Credit, 
Zweite  Halfte,  Berlin,  1879,  pp.  264-5,  who,  because  of  the  fact 
that  purchaser  and  seller,  located  at  different  places,  belong  to 
different  groups  of  recipients  of  credit,  favors  the  granting  of 
accommodation  to  the  purchaser  by  the  purchaser's  bank,  rather 
than  the  discounting  of  bills  of  exchange  by  the  seller  at  the 
seller's  bank,  and  perceives  a  tendency  in  the  first  direction. 


FURTHER  ASPECTS  OF   COMMERCIAL  BANKING  81 

it  gathers  has  become  expert  in  determining  the  worthiness 
of  the  applicants  to  it — in  other  words,  in  measuring  credit. 
It  has  been  found  desirable  to  employ  this  knowledge  in 
guaranteeing  obligations  of  one  enterprise  to  another  with- 
out itself  lending  capital.  The  knowledge  that  its  expert 
judgment  has  approved  of  the  obligation,  and  that  it  stands 
ready  to  hold  itself  liable  in  case  its  judgment  be  found  to 
be  mistaken,  will  suffice  to  secure  accommodation  from 
another  individual  bank.  The  seller,  assuming  that  the  ac- 
ceptance is  granted  in  the  case  of  an  actual  transaction, 
measures  no  credit,  but  in  his  place  both  the  accepting  bank 
and  the  discounting  bank  do  so.  The  acceptance  business 
in  itself  does  not  constitute  banking,  but  its  conduct  by 
banks,  as  in  the  United  States,  affords  rather  another  in- 
stance of  development  along  the  line  of  social  least  resis- 
tance. 


CHAPTER  V. 

SOME   FURTHER   ASPECTS   OF    COMMERCIAL   BANKING    (CONT.) 

1.  We  turn  now  to  a  consideration  of  the  problem  of  the 
extent  to  which  pooling  of  the  social  circulating  capital  is 
effected  through  the  commercial  banking  system.1  The  out- 
standing feature  is  the  lack  of  homogeneity  in  the  economic 
process,  and  the  necessity  for  separate  consideration  of 
several  of  the  stages.  For  the  purpose  at  hand,  the  most 
satisfactory  division  will  be  into  the  extractive,  manufac- 
turing, wholesale,  retail  and  consumptive  stages.  Certain 
features  of  the  process  merely  will  be  considered,  and  no 
attempt  will  be  made  to  treat  in  detail  each  of  the  stages. 

We  turn  first  to  the  extractive  stage,  and  in  connection 
therewith  consider  agriculture.  The  stage  will  be  regarded 
from  two  points  of  view:  (1)  suitability  for  commercial 
loan  operations,  and  (2)  flow  of  funds  therefrom  which  are 
available  for  such  operations.  Let  us  consider  the  former 
first.  Cooperative  application  of  the  social  circulating  capi- 
tal depends  upon  the  existence  of  fluctuations  in  the  activity, 
and  hence  circulating  capital  requirements,  of  the  individual 
business  enterprise.  The  banking  system  does  not  loan  in 
the  case  of  every  transaction  undertaken  by  any  one  enter- 
prise, but  rather  requires  in  general  that  the  enterprise  own 
at  least  an  amount  sufficient  for  its  minimum  requirements, 
the  cooperation  obtaining  in  the  securing  of  the  excess.2 

xIn  the  present  chapter,  the  term  "banking"  again  refers,  unless 
specifically  otherwise  mentioned,  to  commercial  banking. 


FURTHER  ASPECTS  OF  COMMERCIAL  BANKING  83 

More  fruitful,  however,  will  be  a  consideration  of  the  indi- 
vidual loan  operation.  Three  factors  must  be  considered  in 
analyzing  the  same  in  the  various  stages,  in  order  to  deter- 
mine the  suitability  of  the  stage  for  cooperation  in  the  appli- 
cation of  the  social  circulating  capital.  They  are  (1)  the 
length  of  the  stay  of  the  good  in  the  stage  in  question, 

(2)  the  security  of  the  productive  process  in  the  stage,  and 

(3)  the  relative  proportion  which  the  value  of  the  raw 
material  which  is  transformed  in  the  stage  bears  to  the  value 
of  the  finished  product  which  emerges  from  the  stage.3 

The  outstanding  features  of  the  agricultural  stage  are  an 
elongated  production  period  and  an  elongated  marketing 
period.  We  may  now  direct  our  attention  to  the  first.  Alle- 
viation of  the  carrying  burden  of  the  individual  enterprise 
in  the  case  of  an  elongated  period  is  rendered  possible  inso- 
far as  the  carrying  process  may  be  further  subdivided  among 
several  agencies,  the  first  passing  the  good  through  a  certain 
portion  of  the  process,  at  which  point  the  second  takes  it 
up  and  continues  the  passage,  etc.  Certain  physical  attri- 
butes, however,  are  required,  the  commodity  possessing 
practically  its  final  form  utility,  and  practically  being  mar- 
ketable at  each  step.  Moreover,  security  in  the  process  is 
required,  which  however  is  notoriously  absent  in  the  case 

2  In  actual  practice,  however,  ownership  is  unevenly  dis- 
tributed, and  certain  houses  are  carried  by  others. 

3  It  is  apparent  that  the  third  factor  is  no  absolute  guide  to 
the  amount  loaned  over  a  period  of  time,  inasmuch  as  the  fact 
that  the  individual  enterprise  itself  holds  part  of  its  circulating 
capital  requirements  means  that  it  borrows  only  when  its  needs 
exceed  the  amount  of  capital  which  it  holds.  Borrowing  thus 
varies  with  the  scale  of  operations. 

We  cannot  agree  with  Hawtrey's  distinction  between  the  uses 
to  which  the  loan  is  put  by  the  manufacturer  and  by  the  mer- 
chant. The  former  in  his  view  also  receives  as  a  regular  element 
wages  and  expenses  of  working  up  the  raw  material,  as  well  as 
the  cost  of  the  raw  material  itself.     Op.  cit.,  p.  376. 


84 


BANKING   THEORY 


of  agricultural  products,  where  the  risk  element  fs  not  elim- 
inated until  the  final  harvest.  Another  type  of  risk  is  also 
present — superabundance  of  yield  and  consequent  low  price 
per  unit  of  product.  The  risk  factor  is  heightened  by  the 
absence  of  diversification;  where  substantially  a  one-crop 
system  prevails,  the  individual  borrower  stands  or  falls 
therewith,  likewise  also  the  entire  community,  and  thus  the 
borrower  in  other  stages.  Last,  in  the  case  of  ordinary  loan 
operations,  the  value  of  the  raw  material  is  a  considerable 
proportion  of  the  value  of  the  product  which  emerges  from 
the  stage.  Particularly  is  this  the  case  with  the  distributive 
stages,  which  are  ordinarily  conceived  to  be  par  excellence 
the  field  of  commercial  banking.  The  marked  contrast 
existing  between  such  cases  and  agricultural  production  is 
shown  clearly  by  a  consideration  of  the  accompanying 
figure.4 


L 

J  ^^ 

K 

H,^ 

1 

^—~ 

O 

CROWING 


C 
I 


b 

MARKETING 


n 


m 


AGRICULTURE 


MILLING   WHOLESALING 


4  It  will  be  observed  that  we  abstract  in  the  discussion  entirely 
from  fixed  capital  charges,  as  well  as  from  profits.  As  the  rela- 
tive proportions  of  the  several  lines  will  differ  with  the  indi- 
vidual case,  no  attempt  has  been  made  to  obtain  accuracy  in 
drawing  the  figure,  although  certain  standards  exist. 


FURTHER  ASPECTS  OF   COMMERCIAL  BANKING  85 

In  this  schematic  device,  we  trace  grain  through  several 
stages  in  the  economic  process.  As  the  essential  considera- 
tion for  our  purposes  is  price  and  banking  accommodation 
per  unit  of  product,  the  volume  of  product  may  be  neglected. 
Moreover,  the  analysis  may  proceed  upon  the  monetary 
level.  Hence  in  the  figure  the  market  value  or  price  per 
unit  of  the  raw  material  in  the  initial  stage,  namely  seed, 
corresponds  to  A  B,  the  price  of  the  products  at  the  close 
of  the  several  stages,  namely  grain  on  farm  immediately 
prior  to  shipment,  grain  at  close  of  passage  through  primary 
market  and  into  miller's  hands,  flour  sold  by  miller  to  whole- 
sale grocer,  and  flour  sold  by  wholesale  to  retail  grocer,  to 
C  H,  D  J,  E  L  and  F  N  respectively.  It  will  be  observed 
that  the  tangents  of  the  angles  H  A  G,  J  H  I,  L  J  K  and 
N  L  M  will  vary  with  the  increment  in  value  of  the  good 
resulting  from  its  stay  in  the  stage,  while  the  lengths  of  the 
stay  of  the  good  in  each  stage,  as  shown  by  B  C,  C  D,  D  E 
and  E  F  will  correspond  to  the  average  so-called  normal 
production  period  in  each  stage.  Of  the  three  elements  of 
circulating  capital  expenditure,  namely  cost  of  raw  material, 
wages  expended  in  the  transformation  of  the  same,  and  cost 
of  other  articles  used  up  in  the  process,  the  first  provides 
the  basic  element  in  the  individual  loan  operation.5  Where 
an  advance  is  made  to  cover  part  of  the  other  elements  also, 
the  question  of  the  probability  of  the  borrower's  making  an 
actual  contribution  at  least  equal  in  value  to  these  additional 
amounts  arises,  and  hence  the  practice  is  frequently  to  con- 
sider the  latter  amounts  as  a  margin  to  be  supplied  by  the 
borrower.  We  have  just  remarked,  however,  the  insecurity 
of  the  agricultural  stage  in  the  economic  process. 

In  all  economic  activity  involved  in  production   for  a 

6  It  will  be  observed  that  in  the  discussion  in  previous  chap- 
ters, we  at  times  have  tacitly  considered  the  loan  as  limited  to 
this  one  element. 


86  BANKING   THEORY 

market,  an  expenditure  of  effort  anterior  to  the  realization 
of  the  results  therefrom  is  required.  One  cannot  day  by 
day  pluck  the  fruit  of  the  Tree  of  Iyife.  Abstention  now 
means  harvest  later;  these  products  are  then  spread  back 
evenly  over  the  past  production  period.8  But  how  is  this 
to  be  accomplished?  While  in  the  higher  stages  of  the 
economic  process  there  is  a  division  of  the  carrying  burden 
between  a  series  of  enterprises,  there  can,  however, 
from  the  nature  of  the  case  be  no  such  structural  di- 
vision in  the  production  of  agricultural  produce.  In 
consequence,  the  flow  of  income  in  agriculture  is  highly 
seasonal,  reaching  its  peak  at  harvest.  Moreover,  the  geo- 
graphic localization  of  the  principal  types  of  such  produc- 
tion accentuates  the  problem,  the  entire  community  having  a 
heavy  flow  of  income  at  only  one  period  of  the  year,  the 
flow  at  other  times  being  relatively  light.  Thus  we  hear  of 
the  annual  "clean-up"  of  the  South  and  the  Northwest.  The 
products  required  by  the  agriculturalist  however  are  those 
of  the  higher  stages,  food  in  consumption  form,  clothing, 
etc.  Against  the  requirement  of  a  steady  flow  of  such 
products  is  to  be  set  his  flow  of  income  highly  concentrated 
at  certain  seasons  of  the  year.  Within  certain  fairly  well 
defined  limits,  dovetailing  of  uneven  requirements  and  un- 
even contributions  is  not  only  possible,  but  in  fact  provides 
the  basis  for  cooperative  application  of  the  social  circulating 
capital  such  as  is  obtained  through  the  banking  system.  This 
requires,  however,  some  measure  of  synchronization  of  the 
production  periods  of  the  several  types  of  economic  activity, 
as  well  as  a  measure  of  diversification  of  such  activity  within 
a  given  territory.    It  is  patent  that  in  the  case  of  agriculture 

6  A  similar  conception  will  be  found  in  Fisher,  The  Rate  of 
Interest,  New  York,  1907,  pp.  241  ff.,  where  business  loans  are 
conceived  of  as  in  anticipation  of  an  uneven  flow  of  income, 
thus  rectifying  the  resultant  distortion  of  the  income-stream. 


FURTHER  ASPECTS  OF   COMMERCIAL  BANKING  87 

this  in  large  measure  does  not  exist.  It  is  then  necessary 
that  the  manufacturing  sections  carry  the  agricultural  sec- 
tions.7 The  problem  becomes  similar  to  that  presented  in 
the  case  of  international  trade,  in  particular  between  an 
economically  advanced  creditor  nation  and  an  agricultural 
debtor,  where  either  fairly  long  credits  may  be  extended,  or 
a  compensatory  anticipatory  flow  of  exchange  created 
through  the  drawing  of  finance  bills.  An  example  which 
afforded  the  classic  illustration  of  the  use  of  the  finance  bill 
for  the  elementary  texts  in  the  past  has  been  the  trade  be- 
tween Great  Britain  and  the  United  States,  the  bulk  of 
American  exports  going  forward  in  the  autumn  and  winter, 
while  heavy  imports  already  occurred  in  the  spring. 

2.  Part  of  the  analysis  just  made  in  connection  with 
agricultural  loans  may  be  applied  in  the  consideration  of 
the  relation  of  commercial  banking  to  an  enterprise  which 
has  not  confined  its  activities  to  one  of  the  stages  in  the 
economic  process,  but  which  instead  has  taken  unto  itself 
several  other  contiguous  stages  as  well.  Its  sphere  of  opera- 
tions in  its  peculiar  product  may  even  be  so  inclusive  as  to 
roughly  approximate  that  of  the  economic  process  as  a 
whole.  Nor  is  this  a  violent  assumption,  as  the  increasing 
integration  of  industry  with  its  preaching  of  the  economies 
of  large-scale  operation  bears  eloquent  witness,  as  well  as, 
within  more  modest  compass,  the  recent  tendency  to  decrease 
the  number  of  successive  steps  in  commodity  distribution.8 
Let  us  consider  as  typical  the  case  of  an  enterprise  which 
has  extended  its  sphere  of  operations  to  include  the  manu- 

7  Unless  the  agricultural  community  posseses  capital  sufficient 
to  carry  itself,  which  however  in  large  part  is  not  the  case.  As 
is  well  known,  due  to  the  economic  organization  of  agriculture, 
the  loan  to  the  agriculturalist  is  in  large  part  in  kind,  and  the 
local  merchant  is  the  immediate  lender. 

8  Shaw,  op.  cit,  p.  73, 


88  BANKING   THEORY 

facture  of  the  partly  manufactured  good  which  serves  it 
as  raw  material,  and  which  in  addition  has  eliminated  the 
wholesaler  from  the  scheme  employed  in  marketing  its 
product,  the  enterprise  now  selling  direct  to  the  retailer.  It 
thus  embraces  within  its  sphere  of  operations  the  activities 
previously  performed  by  a  series  of  separate  enterprises. 
At  the  close  of  both  of  the  stages  in  the  manufacture  of  the 
product  the  appropriate  potential  form  utility  is  created,  like- 
wise at  the  close  of  the  wholesale  stage  the  appropriate  po- 
tential time  and  place  utility.  But,  as  we  have  seen,  this 
alone  does  not  suffice;  a  market  must  be  provided.  The 
enterprise  has,  however,  in  effect  created  a  market  for  its 
successive  products  in  each  successive  stage  except  the  last. 
In  so  doing  it  has,  moreover,  eliminated  extensive  pur- 
chasing and  selling  operations,  except  at  the  commencement 
and  close  of  the  entire  process.  Attention  will  be  directed 
to  the  factors  which  determine  the  relative  amount  of  the 
loan  in  this  case,  as  compared  with  the  case  in  which  the 
activities  in  which  the  enterprise  engages  are  divided  among 
a  series  of  separate  enterprises. 

The  figure  given  above  may  be  employed,  attention  being 
confined  to  the  stages  marked  lb,  II  and  III.  To  the  enter- 
prise in  question,  the  basic  element  in  the  loan  operation  is 
represented  by  the  line  C  H,  the  loan  occurring  for  the 
duration  of  time  C  F.  On  the  other  hand,  to  a  series  of 
distinct  enterprises,  the  basic  elements  in  their  loan  oper- 
tions  would  be  represented  by  the  amounts  C  H  loaned  for 
the  time  C  D,  J  D  for  D  E  and  L  E  for  E  F.  Inasmuch 
as  the  sum  of  the  latter  may  considerably  exceed  the  former, 
there  may  result,  through  the  requirement  of  increased  own- 
ership of  capital,  severe  penalization  of  the  new  order,  with 
its  economies  of  large-scale  operation.  But  certain  diffi- 
culties arise  in  case  there  be  extension  of  equivalent  accomo- 
dation accorded  the  single  enterprise.  The  central  problem 
concerns  the  legitimacy  of  speaking  of  the  "markets"  which 


FURTHER  ASPECTS  OF   COMMERCIAL  BANKING  89 

the  enterprise  has  created  for  itself  at  the  close  of  each  of 
the  successive  stages.  Where  the  activities  are  performed 
by  a  series  of  separate  enterprises,  the  contribution  made  is 
tested  at  the  close  of  each  successive  stage,  through  th« 
ability  to  transfer  the  good  to  another  entirely  separate  en- 
terprise. In  the  case  in  question,  such  a  test  of  the  con- 
tributions successively  made  is  deferred  until  the  close  of 
the  entire  process,  and  hence  the  risk  of  maladjustment,  con- 
centrated in  the  last  stage,  is  increased.  Congestion  in  this 
last  stage  may  react  with  disastrous  consequences  upon  the 
other  stages.  Though,  in  making  any  loan,  the  banker  must 
look  ultimately  to  the  last  stage  in  the  process,  if  not 
directly  at  least  mediately  as  reflected  in  the  smoothness  of 
the  flow  of  the  product  thru  the  stages  more  proximate  to 
the  stage  in  which  he  is  called  upon  to  loan,  in  the  case  in 
question  this  dependence  of  lower  upon  upper  stages  in  pro- 
duction may  be  attended  with  far  more  drastic  immediate 
results.9  His  analysis  of  course  would  be  based  in  large 
part  upon  the  past  business  history  of  the  enterprise,  and  a 
comparison  of  present  and  anticipated  future  market  con- 
ditions with  those  under  which  the  requisite  success  therein 
indicated  was  achieved. 

3.  We  consider  now  the  final  stage  in  the  economic  pro- 
cess, in  which  the  good  which  passes  through  the  process 
finds  a  final  resting  place.  The  entire  theory  of  banking  is 
predicated  upon  a  final  act  of  liquidation  at  the  close  of  the 

9  Alleviation  becomes  possible  insofar  as  the  products  of  the 
lower  stages  are  at  the  close  of  their  several  stays  therein 
diverted  to  the  general  market  instead  of  passing  to  the  succeed- 
ing stage  in  the  enterprise  iteself.  The  enterprise  in  effect  again 
divides  itself  into  the  several  separate  enterprises  which  it  had 
supplanted.  This  involves  a  gradual  slackening  of  the  activities 
of  the  enterprise  as  a  whole.  Or  again,  the  products  of  the  lower 
stages  may  be  passed  on  to  the  upper,  but  a  variant  of  the  fin- 
ished product  be  introduced  in  the  hope  of  greater  marketability. 


90  BANKING   THEORY 

economic  process.  Liquidation  in  the  last  stage  is  reflected 
back,  as  it  were,  and  renders  possible  liquidation  in  the  pre- 
ceding stages.  This,  of  course,  is  readily  apparent  in  view 
of  the  analysis  contained  in  the  last  chapter  but  one.  In 
considering  the  relation  of  banking  to  the  stage  in  question, 
however,  the  stage  must  be  further  analyzed.  It  may  be 
considered  to  assume  a  twofold  aspect,  according  to  the 
character  of  the  good  which  enters  it.  The  good  may  be 
either  a  consumption  good,  which  gives  us  the  conventional 
conception,  or  a  capital  good,  in  which  event  the  good,  pre- 
viously representing  circulating  capital  to  the  seller,  at  the 
close  of  its  passage  through  the  intermediate  stages  of  the 
process,  represents  fixed  capital  to  the  final  holder  into 
whose  hands  it  passes. 

Let  us  consider  first  the  case  of  a  consumption  good  pass- 
ing from  retailer  to  wage  earner,  and  analyze  the  consump- 
tive stage  from  a  purely  business  point  of  view.10  As  is  well 
known,  a  gap  in  time  customarily  exists  in  such  cases.  Our 
theory  of  commercial  banking,  while  emphasizing  the  func- 
tion of  bridging  a  gap  in  time  between  sale  and  payment  of 
the  purchase  price,  however,  also  implies  the  loan  of  such 
funds  for  a  period  not  longer  than  sufficient  to  enable  the 
buyer-borrower  to  pass  the  goods  through  its  stage  in  the 
economic  process.  How  are  we  to  relate  commercial  bank- 
ing to  the  case  just  noted?  It  will  be  most  fruitful  to  ap- 
proach the  problem  in  a  somewhat  different  manner.  Be- 
tween the  actual  application  of  labor  and  the  ultimate  sale 
of  the  commodity  to  which  the  labor  is  applied — the  time 
when  the  contribution  is  finally  and  definitely  made — a  con- 


10  Substantial  similarity  would  occur  in  considering  recipients 
of  other  sources  of  income,  such  as  from  investments  or  from 
rent  of  property,  in  both  of  which  a  continuing  contribution  is 
made,  while  payment  is  received  only  at  stated  intervals. 


FURTHER  ASPECTS   OF   COMMERCIAL  BANKING  91 

siderable  period  of  time  may  intervene.11  In  the  present 
economic  order,  the  entrepreneur  becomes  mediatory  be- 
tween the  worker  and  society,  and  the  worker  makes  his 
contribution  when  he  sells  his  services  to  the  entrepreneur. 
But  the  present  economic  order  is  predicated  upon  a  group- 
ing of  transactions.  The  application  of  the  principle  of 
efficiency  calls  only  for  the  periodical  payment  of  wages, 
e.g/,  once  a  week.  The  gap  in  time  for  the  worker  thus  in 
point  of  fact  becomes  twofold:  (1)  the  period  between  pay- 
ment by  employer  and  actual  sale  of  the  product  in  which 
the  labor  was  applied,  and  (2)  the  interval  between  payments 
by  the  employer.  The  second  is  bridged  in  point  of  actual 
fact  in  considerable  measure  by  the  retail  merchant,  who 
may  obtain  the  capital  required  in  such  operations  from  the 
banking  system.  The  technical  banking  analysis  which  is 
involved  thus  differs  materially  from  that  largely  prevalent 
in  the  other  stages.  The  combination  of  line  of  credit  and 
cash  discount  system,  as  has  been  pointed  out,  involves  a 
grouping  of  transactions  in  the  buyer's  stage.  In  the  final 
stage  in  the  economic  process,  however,  the  cleavage  instead 
is  along  the  line  of  a  grouping  of  transactions  of  one  seller 
with  different  buyers  of  similar  articles,  instead  of  the  com- 
plete though  diverse  purchases  of  one  buyer.12 

The  final  stage  has  thus  far  in  this  section  been  regarded 
as  one  which  is  required  to  be  carried  by  the  other  stages  in 
the  economic  process.  But  certain  contributions  are  also 
available  from  it.    The  source  from  which  these  funds  are 

11  The  case  presents  considerable  analogy  to  that  of  agricul- 
tural production.     Reference  may  also  be  made  to  note  6,  p.  86. 

12  It  will  be  observed  that  we  abstract  from  the  period  during 
which  the  good  remains  in  the  retailer's  stage  in  the  economic 
process,  which  is  properly  involved  in  the  consideration  of 
mediation  between  wholesale  and  retail  stages,  and  confine  our 
attention  to  time  elapsing  between  receipt  of  good  and  payment 
therefor  by  the  consumer. 


92  BANKING   THEORY 

derived  is  on  the  one  hand  the  regular  recurring  surpluses 
(alternating  with  deficits)  of  some  individuals,13  on  the 
other  hand  the  continual  surpluses  of  others.  The  problem 
is,  of  course,  complicated  by  the  fact  that  the  latter  represent 
largely  funds  to  be  employed  more  or  less  shortly  for  in- 
vestment purposes. 

Points  of  similarity  and  difference  may  be  noted  between 
the  above  analysis  of  the  passage  of  a  final  consumption 
good  and  the  analysis  required  in  the  case  of  the  passage 
of  a  capital  good.  Moulton  has  called  attention  to  the  simi- 
larity existing  between  the  two  corresponding  types  of 
loan.14  That  an  investment  operation  is  represented,  is 
clearly  seen  in  considering  the  fundamental  nature  of  the 
two  pools  of  financing,  which  will  be  discussed  at  greater 
length  in  the  following  chapter.15  Leaving  aside  entirely 
the  question  of  the  source  whence  the  funds  to  be  loaned 
are  derived,  we  may  classify  these  loans  according  to  the 
source  whence  the  funds  upon  which  the  enterprise  itself 

13  The  surpluses  arise  in  connection  with  certain  of  the  trans- 
actions of  each  individual,  as  will  be  the  case  in  considerable 
measure  in  other  parts  of  the  economic  process,  but  are  also 
offset  in  considerable  measure  by  demands  for  funds  from  other 
individuals  who  operate  their  individual  economy  rather  on  the 
opposing  principle  of  anticipation  of  income.  The  analysis  of 
the  transactions  of  the  consumer  from  the  retailer's  point  of 
view,  namely,  as  (1)  seasonal,  such  as  clothing;  (2)  regularly 
recurring  at  intervals,  such  as  men's  furnishings,  and  (3)  regu- 
larly recurring  from  day  to  day,  such  as  groceries,  does  not 
aid  us. 

14  Commercial  Banking  and  Capital  Formation,  II,  Journal 
of  Political  Economy,  Vol.  XXVI,  1918,  pp.  648,  718. 

15  Cf.  in  particular  Section  3.  Inasmuch  as  certain  business  en- 
terprises may  possess  the  capital  for  some  time  previous  to  their 
employment  of  the  same,  while  others  may  require  the  capital 
some  time  prior  to  their  possession  thereof,  it  may  appear  when 
superficially  viewed  that  a  species  of  pooling  is  rendered  possible 
with  respect  to  such  capital. 


FURTHER  ASPECTS  OF   COMMERCIAL  BANKING  93 

relies  are  derived.  We  have  then  (1)  new  investments  of 
saved  capital  obtained  from  without  the  enterprise,  (2)  use 
of  income  received  by  the  enterprise  for  extensions  and 
betterments,  and  (3)  use  of  income  received  by  the  enter- 
prise for  repairs  and  replacements.  It  may  appear  that  there 
is  a  flow  of  income  from  which  the  funds  for  repayment 
may  be  obtained.  But  the  theory  of  commercial  banking 
has  as  an  essential  feature  a  regular  flow  of  goods  through 
the  stages  in  the  economic  process,  and  a  counter  flow  of 
funds  from  which  liquidation  results,  as  the  goods  emerge 
from  the  stage.  An  automatic  upper  limit  to  the  loan  is 
afforded.  In  all  three  cases,  however,  this  is  conspicuously 
absent.  In  the  third  case  no  accommodation  in  point  of  fact 
should  be  required  in  the  well  administered  enterprise.  While 
it  may  be  urged  that  banking. merely  enables  an  anticipation 
of  the  future  control  of  funds,  this  however  means,  to  em- 
ploy an  hypothetical  case,  that  the  enterprise  possesses  only 
the  accumulations  of  nine  months  with  which  to  purchase  a 
tool  which  would  require  the  accumulations  of  twelve 
months.  Such  a  situation  would  be  obviated  were  deprecia- 
tion accurately  calculated.  In  the  second  case  the  enterprise 
will  apply  the  proceeds  from  a  series  of  its  operations  to 
the  purchase  price  of  the  new  equipment.  Two  types  may 
be  distinguished,  the  basis  of  distinction,  which  is  merely 
one  of  degree,  being  (1)  the  relation  which  the  amount  of 
capital  so  employed  bears  to  the  total  capital  equipment  of 
the  enterprise,  and  (2)  the  time  for  which  the  loan  will  be 
made,  which  in  general  will  vary  directly  with  the  first  fac- 
tor. A  large  twilight  zone  however  will  exist,  and  only  for 
illustrative  purposes  may  we  sharply  distinguish  between  the 
two.  In  the  case  in  which  the  relative  amount  of  capital  is 
small,  and  hence  the  time  short,  there  may  appear  to  be 
approximation  from  the  point  of  view  of  time  involved  to 
a  regular  commercial  loan.    In  both  cases,  however,  liquida- 


94  BANKING   THEORY 

ting  power  will  be  obtained  from  the  series  of  successive 
usufructs  from  the  entire  operations  of  the  enterprise  as 
these  accumulate,  not  from  the  emergence  from  the  bor- 
rower's stage  of  goods  which  the  borrower  has  purchased 
with  the  funds  obtained  in  order  to  pass  the  goods  through 
the  stage — in  other  words,  from  that  part  of  sales  represent- 
ing profits,  rather  than  from  the  total  receipts  from  sales. 
Attention  will  be  paid  to  this  difference  in  source  of  liqui- 
dating power  in  the  analysis  made  by  the  lender,  and  assur- 
ance obtained  that  the  sum  total  of  anticipated  profits  during 
the  period  of  the  loan,  as  shown  by  rate  of  turnover  and 
profit  per  individual  turnover,  will  suffice  to  repay  the  loan. 

4.  We  turn  back  at  this  point  to  the  marketing  sub  stage 
of  the  extractive  stage  in  the  economic  process.  Whereas  in 
the  cases  previously  considered  there  has  been  a  horizontal 
flow  of  goods  from  stage  to  stage,  we  have  here  the  apparent 
paradox  that  the  very  force,  organized  speculation,  which 
is  designed  to  further  perfect  the  onward  sweep  of  goods, 
appears  itself  when  viewed  superficially  as  a  frictional  ele- 
ment, abnormal,  if  we  wish  to  employ  the  term,  involving  a 
vertical  flow  of  goods,  due  to  trading  between  enterprises  in 
the  same  stage  of  the  process. 

The  marketing  process  in  the  case  of  the  great  staples,  to 
which  we  will  confine  our  attention,  is  both  elongated  and 
possessed  of  certain  special  features.  During  the  crop- 
moving  season,  which  occupies  from  three  to  four  months, 
the  commodities  become  concentrated  in  the  hands  of  the 
marketing  agencies,  which  gradually  pass  them  into  con- 
sumption during  the  balance  of  the  year.  Greater  "func- 
tional" specialization  has  been  developed  here  among  the 
structural  agencies  than  in  the  upper  stages  of  the  economic 
process.  Several  subsidiary  stages,  as  we  may  denote  them, 
may  be  distinguished.  The  crops  are  gathered  in  the  country 
and  moved  to  the  primary  market,  stored  in  the  primary 


FURTHER  ASPECTS  OF   COMMERCIAL  BANKING  95 

market  during  their  passage  through  it,  and  then  are  passed 
into  the  hands  of  users  or  of  further  intermediaries.  In  this 
process  the  individual  lots  of  commodities  lose  their  identity  ; 
a  title  to  a  particular  lot  becomes  merely  a  claim  to  a  speci- 
fied amount  of  a  particular  grade.  In  the  process,  the  second 
subsidiary  stage  is  of  particular  interest  to  us,  inasumch  as 
the  primary  market  in  the  cases  of  most  importance  is 
typified  by  the  organized  exchange,  such  as  the  Chicago 
Board  of  Trade  or  the  New  York  Produce  Exchange.  More- 
over, the  organized  exchange  is  conventionally  conceived  of 
as  the  home  of  commodity  speculation.16  This  at  once 
raises  the  problem  of  the  relation  of  commercial  banking  to 
such  speculation,  and  the  manner  in  which  this  speculation  is 
financed.  The  study  is  concerned  essentially  with  the  loan 
operation,  rather  than  with  the  cooperation  which  may  be 
obtained  in  the  supply  of  such  capital.  The  treatment  of 
speculation  will  be  relatively  somewhat  extended,  in  order 
to  provide  a  basis  also  for  certain  of  the  discussions  in  the 
following  chapter. 

Speculation  on  the  organized  exchange  is  associated  pri- 
marily with  the  system  of  futures.  But  the  financing  of 
futures  calls  for  relatively  little  capital.  Only  margins,  in 
the  past  usually  ten  per  cent.,  are  required  by  both  parties 
to  a  transaction  as  evidence  of  good  faith  and  pecuniary 
responsibility  until  actual  delivery  is  made,  when  the  entire 
amount  becomes  due.  As  a  large  proportion  of  future  trans- 
actions are  "rung  out,"  in  the  language  of  the  market,  that 

is  We  may  bear  in  mind  the  conception  of  speculation  of 
Lexis  in  Schonberg,  Handbuch  der  Politischen  Oekonomie, 
Vierte  Auflage,  Zweiter  Band,  Zweiter  Halbband,  Tubingen,  1898, 
p.  255:  "The  endeavor  to  appraise  in  advance  the  price  relations 
of  the  near  future,  and  the  governing  of  present  action  by  thes« 
conjectures."  Waiving  all  claim  to  exactitude,  we  may  charac- 
terize price  difference  trading  as  an  essential  feature  of  specu- 
lation. 


96  BANKING   THEORY 

is,  the  differences  merely  settled,  actual  deliveries  are  made 
chiefly  to  miller  or  actual  distributor.  But  the  volume  of 
future  trading  depends  indirectly  upon  the  amount  of  actual 
commodity  available,  as  represented  by  receipts  of  ap- 
proved warehouses.  Without  a  large  basis  of  actual  com- 
modity engaged  in  passing  through  the  process,  extensive 
future  trading,  and  thus  an  extensive  speculative  market, 
cannot  exist.  What  a  specie  reserve  is  to  a  bank,  the  reserve 
of  warehouse  receipts  is  to  the  speculative  exchange.  The 
actual  commodity  in  warehouse  supports  a  mass  of  futures. 
The  greater  the  amount  of  credit  extended  by  the  banking 
system,  say  to  the  terminal  elevator  company  in  the  case  of 
wheat,  and  the  longer  the  period  of  time  for  which  it  is  ex- 
tended, that  is,  the  slower  the  passage  of  the  commodity 
through  the  sub-stage,  the  larger  the  volume  of  speculation 
which  may  be  sustained.  This  relation,  however,  is  limited 
by  the  fact  noted  above  that  there  is  a  given  stock  of  the 
commodity  whose  distribution  is  to  be  spread  over  the  entire 
year;  were  the  adjustment  of  demand,  supply  and  price  ren- 
dered perfect  or  nearly  so  by  the  exchange,  banking  would 
be  impotent  to  influence  in  any  way  the  volume  of  such 
future  speculation. 

5.  But  we  must  consider  at  the  same  time  the  service 
rendered  by  such  speculation.  That  commodity  speculation 
in  the  broad  sense  of  the  term  has  a  definite  role  in  the 
economic  process  no  one  can  legitimately  deny.  The  eco- 
nomic process  is  dynamic,  not  static;  speculation  plays  an 
integral  part  in  this  dynamic  process.  The  services  ren- 
dered are  two-fold.  Speculation  endeavors  to  bridge  the  gap 
created  by  the  modern  capitalistic  system  of  production  be- 
tween producer  and  consumer.17  Though  demand  and  supply 
act  to  fix  prices,  the  prices  so  fixed  react  on  the  consumptive 
propensities  helping  to  determine  demand,  as  well  as  the  pro- 

17  Emery,  Speculation  on  the  Stock  and  Produce  Exchanges  of 
the  United  States,  New  York,  1896,  p.  158. 


FURTHER  ASPECTS  OF  COMMERCIAL  BANKING  97 

ductive  activities  determining  future  supply.  Speculation 
acts  primarily  through  prices  to  render  the  competitive  ad- 
justment of  demand  and  supply  more  perfect.  The  endeavor 
is  primarily  to  attain  an  ever-moving  series  of  static  equi- 
libria; the  mean  levels  of  the  sea  around  which  the  waves 
forever  play,  to  employ  a  familiar  illustration.  Operating 
basically  within  the  stages,  that  is  vertically,  in  place  of 
horizontally  in  the  economic  process,  speculation  endeavors 
to  render  more  even  the  onward  sweep  of  goods  and  to  ad- 
just the  rate  of  flow  of  goods  through  the  process,  as  well  as 
the  rate  of  consumption.  The  existing  supply  is  distributed 
in  the  most  effective  manner.  Finally,  it  determines  the  rate 
of  future  production.  It  is  in  these  connections  that  the  so- 
called  discounting  of  the  future  becomes  of  importance.  If 
the  present  supply  of  goods  be  more  than  ample,  and  ah 
abundant  supply  at  a  relatively  definite  time  in  the  future  be 
in  sight,  the  price  will  be  low,  consumption  and  thus  the  flow 
through  the  stages  will  be  hastened,  and  the  way  opened  for 
the  advent  of  the  new  supply.  On  the  other  hand,  should 
present  supply  be  deficient,  and  future  supply  appear  likely 
to  be  deficient,  the  price  will  be  high,  consumption  and  thus 
the  flow  through  the  stages  will  be  slackened,  and  the  supply 
spread  evenly  over  the  period  in  question.  These  wide- 
spread ramifications  of  speculation  apply  primarily  to  com- 
modities in  the  lower  stages  of  the  productive  process.  Such 
commodities  are  standardized,  homogeneous  in  quality  (so 
that  the  warrant  system  may  be  applied),  and  of  uncertain 
and  to  a  considerable  extent  uncontrollable  production. 
These  conditions,  which  the  great  staples  fulfil  to  a  marked 
degree,  render  organized  exchanges  possible.  Uncertainty 
makes  for  the  system  of  futures ;  in  the  case  of  specialized 
products  the  future  volume  of  which  appearing  on  the  mar- 
ket is  relatively  controllable,  a  system  of  spot  speculation  is 
much  more  likely  to  occur.    But  the  function  of  speculation 


98  BANKING   THEORY 

in  this  case  is  altered  not  a  whit.  The  speculator,  endeavor- 
ing from  his  own  individual  point  of  view  to  create  time 
and  place  utilities,  or  to  decrease  excessive  valuations,  is  still 
contributing  to  the  same  end.ls  In  any  case,  speculation  is 
a  part  of  the  scheme  of  securing  maximum  efficiency  in  the 
economic  process.  Or,  viewed  in  another  light,  it  becomes  a 
moving  factor  in  a  minimal  problem ;  the  completest  possible 
satisfaction  of  wants  with  the  least  possible  expenditure  of 
effort.19  This  service  has  been  called  "the  directive  force 
of  speculation"  which  operates  through  prices.20  In  specu- 
lation traditionally  is  seen  par  excellence  the  doctrine  of  the 
Unseen  Hand. 

In  the  performance  of  this  function  speculation  performs 
another  function  as  well.  Insurance  and  speculation  both 
have  the  same  principal  object;  the  deliberate  assumption 
of  risk.  The  methods  employed  in  the  various  forms  of 
speculation,  however,  differ  widely.  In  commodities  which 
are  the  subject  of  organized  speculation,  there  is  a  special 
class  of  risk  takers.  Just  as  the  body  of  traders  in  becoming 
differentiated  from  the  body  of  producers  assumed  the  risks 

18  We  are  thus  required  to  revise  somewhat  our  exposition  of 
the  creation  of  the  several  species  of  potential  utility  which  was 
given  in  the  second  chapter.  We  abstracted  at  that  time  from 
changes  in  the  estimation  placed  upon  goods.  Speculation  how- 
ever emphasizes  the  fluctuating  character  of  these  estimations, 
differences  both  between  times  and  between  places  existing.  In- 
stead of  the  utilities  being  by  any  means  absolute,  they  are  on 
the  contrary  extremely  variable.  The  test  of  the  utility  of  the 
good  is  in  the  endeavor  to  bring  it  in  relation  to  human  wants. 
Only  when  form  utility  is  associated  with  the  other  two  kinds  of 
utility  does  it  become  actual.  The  actual  utility  is  composite; 
only  for  theoretic  purposes  may  we  endeavor  to  isolate  the 
component  parts. 

19  The  phrase  is  adapted  from  Ernest  Mach's  statement  con- 
cerning science.     Science  of  Mechanics,  Chicago,  1907,  p.  490. 

20  Emery,  op.  cit,  p.  143. 


FURTHER  ASPECTS  OF  COMMERCIAL  BANKING  99 

of  the  market,  so  with  the  widening  of  the  market — now 
become  world-wide— and  the  increase  in  the  risks  attendant 
upon  the  larger  Konjunctur,  a  special  class  of  speculators, 
which  has  become  differentiated  from  the  traders,  has  as- 
sumed the  larger  risks  the  traders  are  no  longer  qualified  to 
assume.21  This  in  itself  has  the  effect  of  reducing  the  risks.22 
A  continuous  market  is  provided.  The  extreme  limits  of 
price  •fluctuations  are  narrowed,  though  the  fluctuations 
themselves  are  more  frequent.23  In  unorganized  speculation 
there  may  or  may  not  be  a  special  class  of  risk  takers.  Typi- 
cal of  the  two  cases  may  be  considered  the  trader  in  real 
estate,  and  the  wholesaler  who  purchases  a  commodity  in 
excess  of  anticipated  demand  of  retailers  in  order  to  dispose 
of  it  again  to  other  wholesalers  at  an  advance  in  price,  which 
latter  species  of  transaction  is  in  fact  quite  common  today.24 
While  organized  speculation  means  a  deliberate  avoidance  of 
risk  by  the  regular  participants  in  the  economic  process,  in 
the  case  of  unorganized  speculation  there  is  often  a  deliber- 
ate assumption  of  risk  by  a  special  class  of  participants  in  the 
expectation  of  using  the  specialized  knowledge  and  skill  ac- 
quired in  their  regular  activity.25  Speculative  business, 
which  may  be  considered  as  the  third  class  of  speculation,  is, 

21  Ibid,  pp.  101-9. 

22  Fisher,  The  Rate  of  Interest,  New  York,  1907,  p.  217. 

23  But  this  does  not  necessarily  imply  more  stable  prices,  for 
conditions  of  demand  and  supply  may  differ  at  different  periods 
Cf.  Emery,  op.  cit.,  p.  125. 

24  Anderson,  op.  cit.,  pp.  253-4.  With  the  scarcity  of  goods 
during  the  last  few  years  it  became  a  familiar  phenomenon  in 
the  textile  markets  in  particular. 

25  Exactly  the  reverse  occurs  in  the  case  of  the  average  man, 
who,  while  price  fluctuations  are  an  integral  part  of  present 
economic  society,  is  always  endeavoring  as  far  as  possible  to 
avoid  them  and  conform  his  actions  to  the  doctrine  of  a  normal 
price. 


100  BANKING   THEORY 

in  fact,  in  a  sense  inherent  in  all  production  for  a  market ; 
certain  risks  are  inherent  in  all  business,  and  cannot  be 
avoided.  It  becomes  in  fact  primarily  a  question  of  whai 
risks  not  specifically  inherent  in  the  business  are  assumed, 
and  its  outlines  are  exceedingly  vague. 

The  virtue  of  the  special  class  of  risk  takers  has  usually 
been  conceived  to  be  the  fact  that  it  makes  hedging  possible 
by  the  other  participants  in  the  economic  process.    With  a 
future  system,  as  we  have  seen,  it  renders  hedging  possible 
not  only  by  those  engaged  in  the  stages  preceding  and  suc- 
ceeding that  in  which  speculation  occurs,  but  as  well  by  those 
engaged  in  passing  the  commodity  through  the  marketing 
stage  in  which  it  becomes  the  basis  of  speculation.    Many  of 
the  futures  then  represent,  not  speculative,  but  hedging  tran- 
sactions.   The  classic  example,  which  has  found  its  way  into 
the  economic  texts,  is  that  of  the  miller,  who  operates  with 
the  two  commodities  which  he  employs  for  the  purpose  26  so 
that,  mathematically  expressed,  px  minus  p2  equals  constant, 
px  and  p2  being  the  prices  of  the  two  commodities  at  any 
moment  of  time.    In  this  case  the  prices  of  the  commodities 
selected  are  directly  related,  hence  the  hedge   is   accom- 
plished through  a  short  sale.     As  has  been  pointed  out, 
however,  hedging  is  a  much  more  universal  phenomenon 
than  is  often  believed.27    It  often  involves  the  second  form 

28  These  two  commodities  may  be  a  spot  and  a  future  of  one 
commodity,  or  a  raw  material  and  the  finished  product  thereof, 
as  well  as  entirely  different  commodities.  In  the  instance  of  the 
miller,  as  the  difference  in  price  between  future  wheat  and  spot 
wheat  is  fixed  at  the  time  of  purchase,  that  is,  is  a  constant,  the 
requirement  is  that  the  difference  in  price  between  the  flour  and 
spot  wheat  (the  future  at  time  of  delivery)  should  be  equal  to  the 
constant.  This  in  fact  is  true  because  the  prices  of  spot  and 
future  wheat  and  flour  all  move  in  consonance. 

27  Brace,  The  Value  of  Organized  Speculation,  Boston  and 
New  York,  1913,  pp.  155  ff.    In  actual  practice  the  offset  in  either 


FURTHER  ASPECTS  OF  COMMERCIAL  BANKING  101 

of  hedge,  where  the  prices  of  the  two  commodities  chosen 
are  inversely  related,  a  rise  in  the  price  of  one  equalizing 
a  fall  in  the  price  of  the  other,  so  that,  mathematically  ex- 
pressed, pj  plus  p2  equals  constant.  Hence  the  hedger  is 
long,  in  the  language  of  the  market  place,  on  both  commodi- 
ties. In  either  case,  the  effect  is  to  preserve  to  the  hedger  the 
trade  profit  on  his  chief  commodity.  No  organized  exchange 
is  necessary  in  either  case,  and  the  virtue  of  organized  spec- 
ulation becomes  rather  the  fact  that  hedging  is  rendered 
easier  through  the  continuous  market  provided  and  the  more 
perfect  price  adjustments  secured.  In  fact,  theoretically,  no 
distinct  speculative  trading  in  the  commodity  which  is  used 
to  hedge  with  is  required. 

6.  In  considering  the  banking  support  tendered  specula- 
tion, differentiation  must  be  made  between  it  and  the  volume 
of  speculative  transactions.  It  is  against  the  latter  that  the 
hue  and  cry  is  raised ;  it  is  gambling,  of  which  the  latter  are 
conceived  largely  to  exist,  that  is  condemned.  But  a  far  bet- 
ter distinction  for  our  purpose,  inasmuch  as  the  gambling 
spirit  underlies  all  speculation,  is  that  between  legitimate 
and  illegitimate  speculation,  between  the  speculation  of  the 
professional  and  the  speculation  of  the  amateur.28  The 
amount  of  amateur  speculation  in  commodities  is,  however, 
relatively  slight ;  the  stock  market  is  the  Mecca  of  the  lamb. 
On  the  organized  exchanges  he  nevertheless  interferes  seri- 
ously with  the  efficacy  of  the  price  fixing  process.  The  only 
virtue  of  such  speculators  lies  in  the  fact  that  they  extend 
the  limits  of  the  market.  The  problem  then  narrows  down 
to  this :  how  large  a  market  is  required  for  the  operation 
of  the  price  fixing  process  ?    Considerable  difference  of  opin- 

case  may  at  times   only  be  exceedingly  rough.     A  measure  of 
compensation  rather  than  exact  equivalence  is  achieved  in  such 
cases. 
28  Ibid.,  Chapters  V  and  VI. 


102  BANKING   THEORY 

ion  exists  as  to  this  point,  especially  as  to  whether  or  not  the 
professional  speculators  can  operate  efficiently  in  a  market 
from  which  the  amateur  is  excluded.     If  the  narrowing  of 
the  market  be  too  great,  certain  consequences  will  follow. 
If,  for  example,  an  attempt  be  made  to  greatly  limit  banking 
support  of  future  transactions,  and  the  amount  of  short  sales 
be  thus  considerably  decreased,  the  market  may  tend  to  be- 
come one-sided,  and  greater  price  fluctuation  result.29    The 
individual  bank  by  lessening  banking  accommodation  will  be 
forced  to  still  further  limit  banking  accommodation,  as  larger 
margins  will  be  required.    The  opportunity  for  hedging  will 
be  decreased,  and  hence  the  opportunity  for  the  regular  busi- 
ness man  to  safeguard  himself.    The  problem  is  not  of  great 
practical  moment,  inasmuch  as  there  has  been  a  great  de- 
crease   in    outside    participation    during    the    last    decade. 
Rather  is  it  unorganized  speculation  and  speculative  busi- 
ness, the  volume  of  which  is  shrouded  in  mystery,  which 
present  a  serious  problem.     Spot  speculation  will  in  these 
cases  in  general  prevail.    Hence  the  market,  even  if  specula- 
tion operate,  will  be  one-sided.    Price  adjustment  will  be  less 
effective   than  in  a  two-sided  market,   for  buying  occurs 
chiefly  for  a  rise;  the  tendency  is  to  level  prices  up,  never 
down.    Hence  the  value  of  speculation  in  these  cases  is  con- 
siderably lessened.     Direct  opportunity  for  hedging,  such 
as  occurs  in  the  lower  stages  of  the  economic  process,  is  af- 
forded much  more  rarely.    The  same  question  of  the  desir- 
able volume  of  speculation  is  again  raised.    Again  the  ideal 
to  be  attained  is  the  same :  the  number  of  transactions  needed 
under  the  existing  division  of  labor  to  efficiently  move  the 
commodities  through  the  stages  in  the  economic  process.30 
20  This   result  will  also  be   accentuated  by   the   fact   that   the 
banking    system   will    prevent    holding   of    commodities    over   a 
period  of  relative  surplus  and  low  price,  and  thus  will  interfere 
with  the  evening  of  prices  which  would  otherwise  occur. 
30  Cf.  Anderson,  op.  cit.,  p.  253. 


FURTHER  ASPECTS  OF  COMMERCIAL  BANKING  103 

Again  the  practical  interpretation  presents  serious  difficul- 
ties— not  only  the  total  amount,  but  also  the  distribution 
thereof  between  the  several  enterprises.  Assuming  this  to 
be  determiner  for  the  transactions  conceived  to  be  legitimate, 
however,  only  the  same  problem  presents  itself  as  in  the  case 
of  other  loans  to  directly  advance  the  goods  in  the  process — 
the  assurance  in  consequence  of  the  loan  of  a  future  output 
within  a  definite  time  at  least  equal  in  value  to  the  amount 
of  the  loan.  As  speculation  implies  risk  assumption,  a  large 
margin  of  safety  must  be  allowed.  The  banking  system 
supplies  funds  to  an  amount  equal  to  the  basic  underlying 
value ;  the  speculator  provides  a  margin  to  cover  possible 
decrease  in  value. S1  While  commodities  in  the  wholesale 
stages  have  a  ready  market,  and  thus  loans  might  be  made 
to  a  higher  percentage,  there  are  countervailing  consider- 
ations in  the  fact  that  they  are  often  sensitive  to  price  fluc- 
tuations, as  well  as  the  fact  that  the  margin  of  profit  is 
smaller.  One  further  problem  remains.  Hedges  of  the  sec- 
ond type  require  double  operating  capital.  This  device  at 
best  involves  considerable  special  waste,  inasmuch  as,  unless 
goods  be  available  as  hedges  whose  economic  process  dove- 
tails with  that  of  the  commodity  whose  price  fluctuations  are 
to  be  hedged  against,  a  considerable  volume  of  goods  may 
at  any  time  be  temporarily  sidetracked  in  the  economic  pro- 
cess in  order  to  serve  as  hedges.  It  would  thus  be  required 
that  virtually  double  banking  accommodation,  allowing  for 
margins,  be  granted  to  an  enterprise  in  order  that  it  might 
safeguard  itself  against  fluctuations  in  the  price  of  its  chief 
product. 

7.  We  may  proceed  now  to  bring  together  certain  of  the 
leading  points  made  above,  in  a  consideration  as  a  whole  of 
the  problem  indicated  at  the  opening  of  the  chapter.     What 

31  This  applies  as  well  to  spot  speculation  upon  the  organized 
exchanges. 


104  BANKING   THEORY 

limits  are  fixed  to  the  pooling  of  social  circulating  capital 
effected  through  the  commercial  banking  system  ?  We  must 
distinguish  at  the  outset  between  the  commercial  character  of 
the  operation  for  which  a  loan  may  be  asked,  and  the  pos- 
sibility of  making  such  loans  upon  a  widespread  scale.  To 
illustrate :  according  to  the  general  principles  of  commer- 
cial lending,  loans  could  be  made  upon  all  mercantile  tran- 
sactions (using  the  term  mercantile  in  a  broad  sense),  and 
the  individual  enterprise  thus  be  required  to  hold  no  cir- 
culating capital  at  all.  The  source  from  whence  the  capital 
in  question  was  derived,  however,  would  then  be  permanent 
savings  owned  by  others  than  the  enterprises  in  question.32 
Commercial  banking,  however,  has  a  different  basis.  The 
underlying  theory  is  built  upon  the  existence  of  deficit  of 
one  enterprise  simultaneously  with  surplus  of  another,  and 
consequently  the  possibility  of  applying  the  one  to  the  other. 
Given  a  certain  amount  of  circulating  capital  in  existence, 
commercial  banking  thus  at  any  one  moment  of  time  en- 
deavors and  tends  to  effect  the  most  efficient  distribution  of 
this  capital.33  This  distribution,  moreover,  is  continually 
changing  from  moment  to  moment. 

For  the  individual  enterprise,  the  above  analysis  would 
seem  to  call  for  the  holding  of  its  average  capital  require- 
ments over  a  period  of  time.  In  point  of  actual  fact,  how- 
ever, no  such  guaranty  is  stressed  in  the  theory  underlying 
the  tests  employed  in  credit  "granting"  at  the  present  time. 
The  requirement  of  a  periodic  "clean  up"  provides  merely 
for  the  holding  of  minimum,  not  average,  circulating  capital 
requirements.34     Nor   does   the   theory  of   the  production 


82  The  degree  of  efficiency  attained  depends  of  course  in  large 
part  upon  questions  of  banking  technique  and  organization. 

33  This  involves  the  same  point  as  made  above  of  the  necessity 
of  considering  the  deposit  as  well  as  the  loan  aspect. 


FURTHER  ASPECTS  OF  COMMERCIAL  BANKING  105 

period  as  applied  to  such  loans  afford  a  better  guide.  Aside 
from  the  practical  features — lack  of  absolute  standardiza- 
tion of  the  period  in  the  distributive  stages,  as  well  as  sea- 
sonal variation  in  the  length  of  the  period  for  the  same  enter- 
prise— the  device  merely  provides  an  upper  limit  to  the  indi- 
vidual loan  transaction,  in  that  the  buyer-borrower,  at  the 
close  of  the  passage  of  the  good  through  his  stage,  will  be 
in  a  position  to  liquidate  the  loan  made  to  him. 

We  turn  now  from  the  circulating  capital  requirements  of 
the  individual  enterprise  to  the  requirements  of  society  as  a 
whole.  At  any  one  moment,  forces  are  at  work  to  effect 
an  adjustment  between  capital  requirements  and  capital  sup- 
ply. But  the  volume  of  such  capital  requirements  is  contin- 
ually changing.  There  is  a  seasonal  concentration,  and  a 
cyclic  change  in  the  volume  of  trade  and  industry  as  well. 
In  consequence,  over  a  period  of  time  we  have  a  series  of 
ever  moving  static  equilibria,  to  effect  which  numerous  forces 
are  at  work.  The  principal  element  of  elasticity  on  the  sup- 
ply side  arises  from  the  new  capital  created,  and  the  option 
existing  of  its  direction  into  either  the  commercial  or  invest- 
ment spheres.  Changes  on  the  demand  side  may  react  on  the 
supply  side  as  well.  Take  the  case  of  advance  in  industrial 
or  marketing  technique.  The  length  of  the  production  period 
will  be  decreased,  with  a  consequent  effect  upon  loan  oper- 
ations, at  the  same  time  that  the  flow  of  income  is  increased. 
Moreover,  increased  output  from  the  existing  fixed  capital 
equipment    may  well   require   a  larger   circulating   capital 

34  This  is  the  second  element  involved  in  this  requirement;  the 
basic  element  is  that  of  affording  evidence  of  liquidating  power 
and  thus  showing  absence  of  application  of  the  capital  to  fixed 
purposes.  Inasmuch  as  certain  enterprises  in  point  of  actual  fact 
own  considerably  in  excess  of  their  average  requirements,  the 
practical  question  in  lending  becomes  rather  one  of  fixing  a 
"safety"  minimum,  which   the  "clean-up"  provides. 


106  BANKING   THEORY 

equipment,  until  equilibrium  is  attained  between  the  amount 
of  capital  devoted  to  the  two  uses.  Thus  not  only  is  there 
continual  attempt  to  attain  equilibrium  between  circulating 
capital  requirements  and  resources,  but  to  preserve  a  balance 
between  these  and  fixed  capital  requirements  and  resources 
as  well. 


CHAPTER  VI. 

INVESTMENT  BANKING 

1.  We  have  seen  that  there  is  a  pool  of  commercial  financ- 
ing. Through  it  effective  utilization  of  the  social  circu- 
lating capital  is  rendered  possible.  The  individual  business 
enterprise  contributes  its  surplus  and  obtains  its  deficit,  the 
cooperative  application  of  the  capital  being  effected  through 
the  institution  of  commercial  banking.  But,  as  we  have  seen, 
there  is  an  investment  pool  as  well,  in  which  the  cooperative 
application  of  the  capital  contained  therein  is  effected  in 
part  by  the  institution  of  investment  banking.  Consider- 
able difference,  however,  exists  between  the  two  pools.  Let 
us  recall  certain  of  the  points  of  contrast  previously  indi- 
cated.1 The  pool  of  commercial  financing  concerns  itself 
exclusively  with  the  social  circulating  capital,  while  the 
pool  of  investment  financing  is  not  complementary,  in  that 
the  sum  of  the  two  pools  equals  the  total  capital  in  existence, 
but  in  point  of  actual  fact  itself  equals  the  latter ;  it  includes 
both  the  fixed  and  circulating  capital  in  existence.  This 
difference  in  area  goes  hand  in  hand  with  a  difference  in  the 
units  between  which  cooperation  is  effected.  In  the  case 
of  commercial  financing,  we  stop  with  the  individual  busi- 
ness enterprise;  in  the  case  of  investment  financing,  we  end 
with  the  individual  himself.  In  the  one  case,  the  lenders 
and  borrowers  are  in  a  broad  sense  one  and  the  same  class ; 
in  the  other,   the  individual  is  the   lending  unit,   whereas 

1  Cf.  Chapter  II,  Section  5. 


108 


BANKING   THEORY 


the  business  enterprise  is  the  borrowing  unit.2  The  under- 
lying purposes  of  the  two  pools  thus  differ.  The  commer- 
cial pool  represents  cooperation  by  business  enterprises  in 
the  employment  of  the  circulating  capital  owned  by  these 
enterprises ;  the  investment  pool  represents  cooperation 
by  individuals  in  rendering  available  for  employment 
by  business  enterprises  the  capital  owned  by  such  indi- 
viduals. In  the  investment  pool,  relative  permanency  is  the 
keynote,  both  on  the  part  of  borrower  and  of  lender. 
There  is  no  such  periodic  liquidity  of  funds,  nor  is  there 
such  frequent  periodic  availability  and  inavailability  of 
funds — alternating  periods  of  surplus  and  deficit — on  the 
part  of  the  individual  enterprise,  as  in  the  commercial 
pool.  The  flow  of  capital  in  the  investment  pool  is  more 
viscous.  Slower  change  occurs  in  the  alignment  of 
recipients  and  lenders,  as  well  as  in  the  general  character 
of  the  investments  represented.  Change  in  the  investments 
occurs  primarily  in  the  direction  of  the  application  of  new 
saved  capital. 

Investment  banking  is  frequently  popularly  held  to  con- 
cern itself  with  the  supply  of  fixed  capital  only,  in  con- 
trast to  commercial  banking,  which  confines  itself  to  the 
supply  of  circulating  capital.  In  the  above  discussion, 
however,  the  basis  of  distinction  has  been  the  time  for 
which  the  capital  is  supplied.  From  this  point  of  view, 
rather  than  from  that  of  use  to  which  funds  are  put, 
was  drawn  the  distinction  between  the  two  pools.  The 
cross    cleavage    between    the    two    criteria    was    remarked 

2  Though  the  business  enterprise  of  course  may  be  resolved 
into  an  association  of  individuals,  and  thus  the  individual  in 
point  of  fact  be  the  ultimate  unit.  The  capital  owned  in  vary- 
ing proportions  by  individual  members  of  the  group  is  thus 
distributed  in  a  different  manner  among  the  members  of  the 
group.  Special  organization  of  the  recipients  in  the  form  of 
corporations,  partnerships,  etc.,  is  frequent. 


INVESTMENT   BANKING  109 

above.3  The  question  arises,  may  we  not  recognize  the 
existence  of  a  pool  involving  merely  the  fixed  capital 
of  society,  and  thus  complementary  to  the  pool  of  com- 
mercial financing.  In  such  a  pool,  the  individual  would 
necessarily  be  the  lending  unit.  Theoretically  only,  however, 
can  we  conceive  of  a  certain  quantity  of  capital  saved  by 
the  individual  members  of  society,  the  composition  chang- 
ing with  the  passage  of  time,  as  an  offset  to  the  fixed 
capital  equipment  of  society.  Practically,  we  cannot  dis- 
sociate the  same  from  the  circulating  capital  so  supplied,  and 
the  concept  is  of  little  value.  It  may  be  remarked,  however, 
that  certain  problems  arise  in  considering  direct  loans  for 
fixed  capital  purposes,  which  will  be  considered  below. 

Corresponding  to  the  difference  in  the  fundamental  pur- 
pose of  the  two  pools  is  a  difference  in  the  technique  by 
which  the  pooling  is  effected.  There  is  a  greater  diversity 
of  factors  in  the  investment  pool,  the  structural  differentia- 
tion is  more  pronounced,  and  there  is  a  difference  in  the 
relative  importance  of  the  roles  played  by  the  factors.  In 
the  commercial  pool  the  structural  elements  are  threefold: 
(1)  the  note  broker,  die  discount  corporation  and  the 
finance  corporation,  (2)  the  commercial  bank,  and  (3)  the 
individual  enterprise  which  either  sells  on  time,  or  which 
purchases  and  holds  commercial  paper  with  its  surplus 
funds.  The  parallel  elements  in  the  investment  pool  are 
as  follows:  (1)  the  trader  in  securities,  such  as  the  bond 
house,  and  including  also  the  corporation  which  resells 
securities  with  its  own  endorsement,  or  issues  its  own  obli- 
gations based  on  these  other  securities,  (2)  the  associa- 
tion of  lenders,  in  the  form  either  of  savings  bank,  holders 
of  time  deposits  or  inactive  accounts  in  a  so-called  "com- 
mercial"   bank,    insurance   company   conducted   upon   the 

s  Cf.  Chapter  II,  Section  4. 


110  BANKING   THEORY 

actuarial  principle  of  reserves  as  distinguished  from  the 
actuarial  principle  of  distribution  of  loss,  or  cooperative 
bank.4  and  (3)  the  individual.  We  will  concentrate  our 
attention  upon  the  second  factors.  In  both  investment  and 
commercial  spheres,  banking  concerns  itself  with  the 
assembling  of  capital ;  in  the  commercial  sphere,  however, 
it  concerns  itself  equally  with  the  distribution  thereof.5 
Owing  to  the  character  of  the  purposes  to  which  such  loans 
are  applied,  and  the  corresponding  duration  of  the  loan,  a 
change  in  the  total  volume  thereof  is  rendered  possible.    On 

4  A  word  concerning  the  cooperative  bank  may  not  be  out 
of  place.  In  consequence  of  the  fact  that  ultimate  borrowers 
and  lenders  are  in  the  aggregate  one  and  the  same  body,  these 
organizations  are  concerned  equally  with  the  gathering  and  dis- 
persion of  capital.  The  process  in  essence  is  as  follows:  A 
group  of  individuals  wish  each  to  do  a  certain  thing  requiring  a 
certain  amount  of  capital.  None  of  them  has  the  required 
amount,  nor  will  the  individual  surplus  per  period  of  time  suf- 
fice. But  by  pooling  this  surplus,  one  individual  of  the  group 
will  be  enabled  to  do  the  desired  thing  during  each  period.  In 
consequence,  all  members  contribute  their  surplus  to  a  common 
fund,  which  at  the  end  of  the  first  period  of  time  renders 
available  the  required  amount  for  one  member  of  the  group, 
at  the  end  of  the  second  period  for  another,  and  so  on  until 
the  members  of  the  entire  group  have  accomplished  their  pur- 
poses. In  other  words,  through  this  pooling,  we  secure,  for 
example,  assuming  that  a  building  and  loan  association  has  been 
the  organization  in  question,  the  creation  of  one  house  every 
year  for  fifteen  years  instead  of  fifteen  houses  at  the  end  of 
fifteen  years.  The  fact  that  in  practice  the  needs  of  the  several 
individuals  may  differ,  and  that  an  effort  is  made  to  attract 
outside  funds,  does  not  vitiate  the  basic  principle.  This  en- 
deavor means,  however,  that  such  organizations  must  issue  their 
own  long  term  securities.  They  present  in  some  ways  too  a 
rather  marked  analogy  to  savings  banks,  except  that  savings 
banks  represent  a  pooling  of  lenders  only. 

6  The  only  parallel  in  the  investment  sphere  is  found  in  the  co- 
operative bank,  which  is  of  relatively  minor  importance. 


INVESTMENT    BANKING  111 

the  other  hand,  through  the  association  of  lenders,  the  with- 
drawal of  certain  enterprises  from  the  circle  of  lenders  is 
compensated   broadly   speaking   by   the   advent   of   others. 
Thus    its     funds     again    become    available    automatically 
to  the  individual  lending  enterprise  through  the  commer- 
cial banking  system.     In  the  investment  sphere,  however, 
this  availability  is  attained  in  another  manner.    Whereas  in 
the  commercial  pool  the  discount  market  is  primarily  a  ques- 
tion of  the  internal  organization  of  the  banking  system,  in 
the  investment  pool  the  security  market  plays  a  far  wider 
role.    In  the  investment  pool  the  individual  investor  bulks 
large  among  the  sources  of  capital  supply.     In  general  he 
holds   title   to   a   specific   security   rather   than   what   is   in 
effect  claim  to  a  proportionate  share  of  the  total  holdings 
of  a  group.   For  him,  shift  of  his  investment  is  accomplished 
only  through  sale  to  another  individual  or  perchance  to  an 
association.      Moreover,    in    case    the    depositors    of    the 
association  call  upon  it   for   funds,   in  the  absence  of  the 
self-liquidating  feature  in  its  loans  and  investments,  it  must 
have  recourse  to  the  security  market.     Thus  a  broad  open 
market  is  indispensable.   It  is  in  this  connection  that  security 
speculation  performs  its  first  function,  to  which  attention 
will  be  directed  presently. 

Considering  now  merely  the  investment  pool,  the  forms 
which  the  "investment"  of  capital  assumes  therein  are  three 
fold:  (1)  ownership  of  securities,  (2)  loans  on  securities, 
made  largely  either  to  bond  house  or  speculator,  and  (3) 
direct  loans  to  the  individual  enterprise.  The  individual 
engages  only  in  the  first  class  of  activity;  the  association, 
however,  engages  in  all  three.  We  will  concentrate  our  at- 
tention largely  upon  the  association,  that  is,  upon  invest- 
ment banking,  in  its  loan  aspects.  In  the  case  of  the  second 
category,  it  assists  in  the  direction  of  the  flow  of  capital 
into  investment,  either  through  loans  to  enterprises  engaged 
in  what  is  akin  in  certain  ways  to  a  species  of  commercial 


112  BANKING   THEORY 

activity,  or  else  in  providing  capital  equipment  to  the  basic 
value  element  in  the  securities  involved,  during  what  we 
may  term  the  process  of'seasoning."6  In  the  latter  case  the 
speculator — a  special  class  of  individual  holder — supplies 
the  fluctuating  additional  amount.  Speculation  here  per- 
forms its  second  function,  namely,  that  of  directing  the 
flow  of  capital  into  investment.  Direct  loans  to  the  indi- 
vidual enterprise,  in  order  to  involve  the  time  element,  are 
practically  made  for  employment  as  fixed  capital.  As  noted 
above,  there  is,  however,  a  shading  in  time,  both  of  loan  and 
of  operation  to  which  the  same  is  applied,  between  such 
loans  and  commercial  loans,  and  a  large  twilight  zone  exists. 
2.  In  examining  at  greater  length  the  service  of  security 
speculation  in  the  investment  pool,  it  will  be  desirable  to 
take  as  a  point  of  departure  that  part  of  investment  bank- 
ing which  has  been  designated  as  "commerce  in  securities." 
The  flow  of  capital  will  be  considered  in  the  reverse  direc- 
tion, rather  as  a  flow  of  securities  than  as  a  flow  of  capital. 
The  conventional  conception  of  the  process  as  given  in  the 
usual  treatises  dealing  with  corporation  finance  is  that 
typified  by  wholesale  and  retail  bond  house  and  savings 
bank.  But  there  is  another  process  as  well.  All  securities 
pass  through  a  speculative  stage  and  a  safe  stage;7  though 
the  former,  while  evanescent  in  some  cases,  may  conceiv- 
ably endure  a  considerable  length  of  time  in  others,  ulti- 
mately the  transition  must  occur.  Considering  a  new  issue 
of   securities,    the   initial   step   is    that   of   grading.      This 

6  The  two  classes  of  security  are  roughly  typified  respectively 
by  bond  and  share. 

7  The  choice  of  the  above  terms  is  perhaps  not  an  example 
of  particularly  felicitous  phraseology.  As  will  be  evident  from 
the  discussion  to  follow,  the  term  "safe"  connotes  merely  lack 
of  uncertainty  as  to  conditions  surrounding  the  enterprise  whose 
securities  are  under  consideration,  and  hence  absence  of  erratic 
price  fluctuations. 


INVESTMENT    HANKING  113 

speculation8  is  believed  to  perform.  Assuming  that  nominal 
rate  of  interest  and  date  of  maturity  have  been  fixed,  this 
involves  the  determination  of  the  market  value  of  the  obli- 
gation; in  other  words,  the  determination  of  the  implicit 
rate  of  interest,  to  employ  Fisher's  terminology.  In  the 
case  of  safe  securities,  all  the  conditions  surrounding  the 
underlying  "security"  are  known ;  in  the  case  of  speculative 
securities,  there  is  of  necessity  a  continual  readjustment  of 
market  value  to  variations  in  "security"  and  income.0 
Assumption  of  risk  of  fluctuations  in  value  is  concentrated 
in  the  common  stock,  and  purchasers  thereof  deliberately 
assume  collectively  the  role  of  risk  bearer  for  the  security 
holders  of  the  enterprise  in  question,  which  role  becomes 
negligible  only  in  case  the  risk  has  become  standardized. 
The  suppliers  of  capital  in  both  cases  differ;  in  the  one  the 
investor,  properly  speaking,  so  acts,  while  in  the  other 
the  speculators  themselves  collectively  act  as  the  imme- 
diate source  of  capital  supply.  After  the  security  has 
demonstrated  its  worth,  or  the  exact  degree  of  worth,  if 
that  merely  were  in  doubt,  the  speculators  slip  quietly  out, 
liquidating  their  holdings  and  passing  to  other  more  uncertain 
and  therefore  more  congenial  fields,  and  the  investors  enter. 
If  the  security  again  later  enter  the  fold  of  the  doubtful, 
the  investors  make  their  exit,  and  the  speculators  again 
romp  merrily  within  its  confines.  Speculation  thus  serves 
to  bridge  an  intermediate  stage  in  the  life  history  of  a 
security. 

This  gives  us  the  conventional  conception  of  the  role  of 
security  speculation.   But  speculation  is  not  a  static  phenom- 

8  We  confine  ourselves  in  the  following  discussion  to  what 
we  may  term  spot  speculation,  as  commonly  practiced  upon 
the  American  exchanges. 

9  The  two  senses  of  the  word  "security"  as  employed  in  this 
sentence  will   be    readily   distinguished. 


114  BANKING   THEORY 

enon;  rather  is  it  dynamic,  and  associated  primarily  with 
the  periodicity  of  economic  life.  Hence  a  refinement  of  the 
above  has  developed.10  While  some  securities  have  passed 
through  the  speculative  stage,  and  some  have  passed  their 
entire  life  history  thus  far  therein,  others  continually  flow 
alternately  through  a  speculative  and  an  investment  period. 
In  any  event,  the  periods  are  unstable.  The  speculator 
carries  stocks  over  the  period  of  uncertainty.  With  the  up- 
ward turn  of  the  business  cycle,  speculation  becomes  active ; 
the  speculators  perceive  the  investment  possibilities  of  securi- 
ties, both  old  and  new,  of  which  a  considerable  amount  now 
commence  to  make  their  appearance.  As  dividends  and  the 
fruits  of  prosperity  become  available,  investors  enter  the 
market ;  they  appreciate  the  virtues  of  securities,  though 
somewhat  later  than  did  the  speculators,  who  in  conse- 
quence receive  an  increased  price  as  reward  for  their  fore- 
sight. Near  the  peak  of  the  price  level,  few  investors,  how- 
ever, make  purchases ;  the  effect  of  the  turn  in  prices  is 
merely  to  decrease  the  number  of  speculators  through  the 
elimination  of  the  unfortunates  who  had  been  too  optimistic. 
Moreover,  increased  investment  occurs  again  to  some  extent 
at  the  lower  prices,  which  attract  investors  whose  marginal 
demand  prices  these  represent.  There  is  thus  a  fairly  satis- 
factory absorption  of  securities  by  investors.  This  theory 
would  apply  equally  both  to  the  grand  sweep  of  the  business 
cycle  and  to  the  minor  fluctuations.  In  the  performance  of 
this  role,  security  speculation  is  conventionally  conceived 
of  as  performing  a  function  similar  to  the  directive  func- 
tion of  commodity  speculation.  Just  as  the  distribution  of 
goods  is  guided  in  time  and  place,  so  also  is  the  flow  of 
capital    guided    from    industry   to    industry    through    price 

10  The  various  aspects  of  this  conception  are  considered  in 
Osborne,  Speculation  on  the  New  York  Stock  Exchange,  Sep- 
tember, 1904-March,  1907,  New  York,  1913. 


INVESTMENT    BANKING  115 

differentials  (in  rates  of  return)  established  between  the 
obligations  of  the  several  industries.  Moreover,  speculation 
anticipates  the  investment  demand,  judgment  as  to  the 
actual  absorptive  power  of  the  market  being  thrust  upon  the 
speculators.  Through  the  fixing  of  the  general  rate  of 
capitalization,  it  attains  equilibrium  between  the  funds  of 
investors  and  the  desires  of  enterprises.  Otherwise  phrased, 
speculation  directs  the  flow  of  capital  into  investment.  It 
will  be  apparent,  however,  that  considerable  difference  exists 
between  the  manner  in  which  commodity  and  security  spec- 
ulation perform  these  parallel  functions,  and  the  analogy 
cannot  be  pressed  too  closely. 

Speculation  provides  a  market  for  securities  by  creating 
a  special  class  of  purchasers.  But  it  benefits  alike  the  cor- 
poration whose  future  is  tinged  with  uncertainty,  and  the 
investor  who  now  holds  securities.  The  former  we  have 
considered  at  some  length,  and  need  not  elaborate  further. 
The  benefit  to  the  investor  occurs  in  two  cases ;  where  the 
security  is  passing  from  the  investment  into  the  speculative 
stage,  or  vice  versa,  where  it  is  as  yet  incompletely  ab- 
sorbed by  investors.  In  these  two  cases  speculation  com- 
pensates for  the  lack  of  investment  demand,  and  supple- 
ments the  new  capital  of  investors  by  providing  both  a 
flow  of  capital  into  new  investments  and  a  means  of  render- 
ing possible  the  ready  sale  of  securities.  The  present  holder 
of  securities  is  enabled  to  dispose  of  the  same  at  will, 
thus  rendering  it  possible  for  him  to  protect  himself  against 
price  fluctuations,  to  shift  his  investment  when  he  so  desires, 
or  to  convert  the  same  into  liquid  funds.  Nor  is  this  service 
of  risk  assumption  slight.  While  enterprises  are  as  stable 
under  the  newer  economic  regime  as  under  the  old,  indi- 
vidual property,  which  has  to  be  assembled  in  increased  mass 
to  equip  these  enterprises,  tends  to  become  more  mobile. 
The  "loan"  made  to  the  corporation,  as  evidenced  by  cer- 
tificates of  stock  and  bonds,  is  not  intended  to  be  repaid  at 


116  BANKING   THEORY 

maturity,  for  the  value  of  the  enterprise  as  a  going  concern 
frequently  far  exceeds  the  value  of  the  assets  when  dis- 
sociated therefrom.  To  the  individual  investor,  on  the  other 
hand,  an  investment  once  made  does  not  now  mean  an  in- 
vestment forever.  Shiftability  is  demanded,  and  obtained 
through  the  mechanism  just  indicated,  of  which  speculation 
is  an  integral  part.  By  this  means  a  shifting  set  of  holders 
against  the  totality  of  existing  securities  is  rendered  pos- 
sible, and  the  barter  of  investments  between  individuals,  also 
the  exchange  of  the  same  with  new  savers  for  their  fluid 
wealth,  is  effected. 

3.  As  suggested  above,  investment  banking  may  be  resolved 
into  several  types.11  Considered  from  the  point  of  view  of 
method  of  investment  of  funds,  we  have  the  direct  loan  to  a 
business  enterprise  which  will  be  employed  by  it  for  fixed 
capital  purposes,  the  loan  on  securities,  either  to  those  en- 
gaged in  what  has  been  termed  commerce  in  securities,  or 
in  speculation,  and  the  direct  holding  of  securities.  Con- 
sidered from  the  point  of  view  of  manner  in  which  funds 
are  obtained,  we  have  on  the  one  hand  savings  deposits  and 
time  deposits  of  the  so-called  "commercial"  bank,  on  the 
other  hand  its  inactive  checking  accounts.  Let  us  consider 
here  the  deposit  aspect.  Both  of  the  types  mentioned,  as 
is  also  the  case  with  commercial  banking,  represent  an 
application  of  the  law  of  averages,  in  that  from  a  large 
number  of  individual  deposit  accounts  practically  or  act- 
ually repayable  on  demand  (i.  e.,  realizable  at  will  in  goods 
or  services  by  the  holder),  there  is  obtained  a  sum  of 
capital  roughly  fairly  constant  in  amount.  With  the  sav- 
ings deposit,  actual  saving  prior  to  the  making  of  an  in- 

11  Abstraction  is  made  in  the  discussion  which  follows  from 
insurance  conducted  upon  the  actuarial  principle  of  reserves  and 
from  cooperative  banking.  The  extent  of  the  applicability  of 
the  exposition  in  the  text  to  both  types  will  be  readily  apparent 
to  the  reader. 


INVESTMENT   BANKING  117 

vestment  or  loan  is  requisite.  Not  so  with  the  demand 
deposit.  In  this  case  the  technique  of  commercial  bank- 
ing is  applied  in  the  investment  sphere,  and  it  is  assumed 
that  no  difficulty  will  be  experienced  in  obtaining  indi- 
viduals or  enterprises  to  "hold"  the  loan  or  investment,12 
reliance  being  placed  upon  the  existence  of  saving  sufficient 
in  volume  and  permanence  to  support  the  given  operations. 
In  this  case  the  demand  deposits  may  also  serve  as  a  circu- 
lating medium,  and  there  is  coalescence  of  permanent  capital 
supply  and  currency.  The  process  is  more  refined  than  in 
the  case  of  the  savings  deposit,  and  presents  consider- 
able technical  difficulty. 

In  order  to  understand  the  process  clearly,  it  is  neces- 
sary to  remember  that,  while  steel,  for  example,  is  in  process 
of  being  fashioned  into  a  machine,  and  until  the  finished 
machine  passes  from  the  hands  of  the  manufacturer  thereof 
into  those  of  the  user,  the  transactions  which  occur  are  in 
the  commercial  sphere,  and  the  compensating  deposit 
credits  which  are  to  be  set  over  against  the  goods  repre- 
sented, are  held  by  business  enterprises.  When  the  machine 
reaches  the  hands  of  him  who  will  employ  it  as  a  finished 
active  production  good,  the  deposit  credit  must  be  held  in 
the  investment  sphere.  The  deposit  is  merely  a  device 
through  which  to  effect  the  "pairing"  process  of  abstinence 
on  the  part  of  one  who  has  made  a  contribution  to  the 
social  product  with  the  obtaining  of  a  good  by  one  who  has 
not  made  such  a  contribution.  In  other  words,  it  serves 
merely  to  enable  one  individual  to  assign  his  claim  to 
another,  and  thus  to  supply  the  required  capital.  Ler  us 
take  first  the  case  in  which  what  we  may  term  the  invest- 
ment banking  principle  is  employed.  Here  the  individual 
transfers  the  demand  deposit  credit  which  he  has  obtained 

12  As  is  well  known,  the  number  of  successive  holders  will  be 
less  than  in  the  commercial  sphere. 


118  BANKING   THEORY 

in  return  for  a  previous  contribution  made  either  by  him- 
self or  another,  to  the  investment  banking  system  in  return 
tor  a  savings  or  time  deposit.  The  investment  banking 
system  transfers  the  demand  depcsi:  to  a  business  enter- 
prise, which  purchases  therewith  a  good  which  it  will 
employ  as  a  finished  active  production  good.  Savings 
depositor  and  the  enterprise  using  the  good  "pair."  The 
manufacturer  of  the  machine  receives  the  demand  deposit 
in  exchange  for  his  machine,  which  deposit  credit  "pairs" 
with  ihe  original  contribution  made  by  either  the  individual 
or  on  the  individual's  behalf.13  This  exposition  assumes 
however  that  the  investment  banking  system  and  the  com- 
mercial banking  system  are  structurally  distinct.  Where 
this  is  not  the  case,  and  the  same  organization  conducts 
both  types  of  banking,  the  initial  deposit  credit  is  at 
first  canceled.  By  virtue  of  the  savings  deposit,  the  crea- 
tion of  a  new  demand  deposit,  however,  is  rendered  pos- 
sible, which  is  then  transferred  in  the  manner  just  indi- 
cated. Where  the  commercial  banking  principle  is  em- 
ployed, the  situation  appears  som,ewha,t  more  complex. 
Here  the  initial  deposit  credit  is  of  a  demand  nature, 
and  is  the  means  of  commencing  a  series  of  exchanges  in 
the  commercial  sphere.  Only  as  deposits  which  were  for- 
merly of  an  active  character  are  becoming  inactive,  or 
as  the  loans  or  investments  of  old  inactive  deposits  are  being 
repaid,  is  it  possible  to  do  this.  Such  deposits  "pair"  with 
the  production  good  received  by  the  enterprise,  and  the 
contribution  which  the  holder  of  the  inactive  deposit  has 
made  pairs  with  the  demand  deposit  held  by  the  seller  of 
the  production  good.    This  means  then  that  certain  demand 

13  As  remarked  in  Chapter  III,  we  cannot  of  course  attempt 
to  trace  throughout  their  entire  life  history  the  particular  de- 
posit credits  arising  in  connection  with  a  given  loan  or  invest- 
ment operation. 


INVESTMENT    BANKING  119 

deposits  migrate  from  the  realm  of  the  active  to  that  of  the 
inactive;  in  other  words,  that  they  transfer  from  the  com- 
mercial to  the  investment  sphere.  In  the  investment  sphere 
they  thus  function  as  offset  against  that  part  of  the  exist- 
ing volume  of  loan  and  investment  operations,  in  the  sup- 
ply of  funds  for  which  the  commercial  banking  principle 
is  employed.  The  loan  or  investment  is  made  and  the  demand 
deposit  is  created  on  the  assumption  that  elsewhere  there 
exists  an  inactive  demand  deposit  which  may  serve  in  the 
pairing  process  indicated.  The  process  is  unlike  that  which 
prevails  in  the  case  of  commercial  banking  in  that  the 
subsequent  holders  of  the  deposit  credit  do  not  success- 
ively act  as  the  source  of  supply  of  the  capital  required 
in  the  initial  operation.14 

In  investment  banking  there  is  no  distinctive  process 
of  cancellation.  Because  of  the  fact  that  there  will  be  no 
counter  flow  of  gcxls  in  the  near  future  from  the  recipient 
of  funds,  a  holder  is  required  of  a  deposit  which  "pairs" 
with  the  good  obtained  by  the  recipient  of  funds.  The 
capital  is  supplied  for  permanent  use,  whether  through  the 
manner  in  which  applied  by  the  recipient  (in  the  case  of  the 
direct  loan),  or  through  the  fact  of  participation  in  the 
enterprise,  either  by  the  banking  system  (in  the  case  of 
direct  holding  of  securities) ,  or  by  an  intermediary  who  ob- 
tains funds  from  the  banking  system  (in  the  case  of  the 
loan  on  securities).  As  the  individual  depositor  exercises 
his  prerogative  to  withdraw,  another  must  take  his  place. 

14  For  the  sake  of  ease  of  exposition,  a  simple  case  has  been 
considered  in  this  paragraph.  No  additional  theoretic  principles 
would  emerge  in  passing  to  more  complex  cases,  such  as  where 
there  are  intermediaries  introduced  in  the  form  of  bond  houses 
or  speculators,  or  where  part  of  the  capital  obtained  is  em- 
ployed by  the  recipient  as  circulating  rather  than  fixed  capital. 

It  will  be  observed  that  we  have  spoken  in  the  text  of  "pair- 
ing" between  deposit  credits  and  goods,  as  well  as  between  in- 
dividuals.    Two  separate  levels  of  the  analysis  are  represented. 


120  BANKING   THEORY 

Where  the  investment  banking  principle  is  employed,  the 
savings  or  time  deposit  is  canceled  and  the  holder  receives 
a  demand  deposit,  which  places  him  upon  the  same  plane 
with  the  individual  holder  of  the  deposit  credit  in  cases 
where  the  commercial  banking  principle  is  employed.  In 
either  case  he  then  employs  it  in  the  commercial  sphere  to 
obtain  the  good  or  service  which  he  desires,  and  cancellation 
of  the  deposit  credit  is  effected  in  the  manner  indicated 
above  in  connection  with  the  discussion  of  commercial  bank- 
ing.18 Another  illustration  is  afforded  by  the  repayment 
from  the  proceeds  of  the  sale  of  securities  of  a  loan  made 
to  a  bond  house  or  speculator.  Here  a  shift  is  made  in  the 
holding  of  the  security,  and  in  place  of  the  individual  de- 
positor who  supplied  the  required  capital,  an  individual 
investor  now  holds  directly  the  securities  in  question.  The 
direct  loan,  however,  may  be  repaid  from  the  profits  derived 
from  the  operations  of  the  borrowing  enterprise.  Cancel- 
lation will  then  occur  as  such  funds  are  applied  to  the 
reduction  of  the  principal  of  the  loan,  either  successively 
or  only  at  the  expiration  of  the  loan  to  effect  repayment  of 
the  total  amount,  and  equivalent  demand  deposit  credits 
are  turned  over  to  the  investment  banking  system.  In  this 
case  a  counter  flow  of  goods  extending  over  a  period  of 
time  represented  by  the  duration  of  the  loan  may  be  con- 
sidered to  occur,  consisting  of  a  part  of  the  goods  regularly 
produced  by  the  enterprise  in  question.16  In  last  analysis 
cancellation  occurs  rather  in  connection  with  the  operation 
of  technical  devices  whereby  goods  are  exchanged,  namely, 
the  loan  and  the  deposit,  which,  created  to  effect  the  ex- 

15  Cf.  Chapter  III,  Section  5. 

16  Difficulty  is  experienced  in  attempting  to  broaden  this  con- 
ception to  include  cases  where  no  loan  has  been  made  to  an 
enterprise,  but  where  its  securities  have  been  purchased  instead. 
In  such  cases,  the  profits  of  the  enterprise  result  merely  in  giv- 
ing  it    control    over    an    increased    amount    of   demand    deposit 


INVESTMENT   BANKING  1  _i  1 

change,  are  canceled  when  they  have  accomplished  their 
purpose.  The  active  demand  deposit  brings  into  the  hands 
of  the  business  enterprise  the  good  destined  to  serve  it  as 
passive  intermediate  or  finished  production  good ;  the  in- 
active demand  or  time  or  savings  deposit  renders  it  pos- 
sible for  the  enterprise  to  continue,  in  the  absence  of  direct 
supply  of  capital  to  it  by  an  individual  investor,  to  possess 
this  good.  In  essence  a  barter  of  goods  is  thus  effected,  in 
investment  as  well  as  in  commercial  banking. 

4.  It  will  be  apparent  that  investment  banking  involves 
a  judgment  as  to  how  far  loan  and  investment  operations 
may  proceed  with  safety.17  This  problem  presents  a  twofold 
aspect:  (1)  the  amount  of  funds  available  in  the  invest- 
ment banking  system  for  such  investment,  and  (2)  the 
possibility  of  realizing  upon  the  investments  held.  The 
first  involves  consideration  of  the  activity  of  accounts,  as 
well  as  judgment  of  the  amount  of  new  saving  which  will 
find  its  way  into  the  investment  banking  system.  The  second, 
which  is  one  phase  of  the  so-called  "liquidity"  problem,  and 
concerns  itself  primarily  with  securities,  is  more  largely  a 
problem  of  the  individual  unit  than  of  the  system  as  a  whole. 
It  involves  judgment  of  the  amount  of  new  and  continued 
saving  held  outside  the  system,  and  the  consequent  oppor- 
tunity afforded  to  turn  over  to  outside  investors  certain 
of  the  investments  held,  as  well  as  the  possibility  of  meet- 
credits,  which  it  may,  as  it  chooses,  either  distribute  to  its 
stockholders  or  employ  in  its  operations.  There  is  no  ultimate 
direct  offsetting  process.  It  may  be  noted  that  in  the  case  of 
direct  holding  of  securities  by  the  investment  banking  system, 
for  that  part  of  the  funds  represented  which  is  employed  by  the 
recipient  enterprise  as  circulating  capital,  a  greater  volume  of 
demand  deposit  credits  merely  continues  in  existence  over 
against  the  securities. 

17  It  is  obvious  that  a  similar  problem  exists  also  in  the  case 
of  commercial  banking. 


122  BANKING   THEORY 

ing  withdrawals  by  selling  some  of  the  securities  in  the 
market,  where  they  are  then  purchased  by  former  deposit- 
ors, part  of  the  assets  thus  in  effect  being  turned  over  to 
depositors  who  have  withdrawn  from  the  group.18  We 
will  consider  first  the  deposit  aspect.  Greater  difficulty  in- 
heres in  the  application  of  the  commercial  banking  prin- 
ciple than  in  the  employment  of  the  savings  banking  prin- 
ciple. Because  of  the  demand  character  of  the  deposits,  and 
consequent  capacity  to  serve  as  currency,  withdrawal  of  the 
same  may  be  effected  without  direct  notification  to  the 
individual  bank  that  they  are  to  be  employed.  The  employ- 
ment of  the  savings  banking  principle,  too,  insures  the  exist- 
ence of  sufficient  saving  at  the  outset,  although  no  more 
definite  assurance  is  afforded  through  its  use  that  these 
deposits  will  not  be  employed  than  where  the  commercial 
banking  principle  is  employed.  Not  only,  however,  is  the 
future  volume  of  funds  not  definitely  known,  but  at  any 
one  moment  the  exact  limits  of  commercial  fund  and  in- 
vestment fund  are  exceedingly  ill  defined.  In  the  disposi- 
tion of  the  capital  holdings  of  the  individual,  the  psycho- 
logic factor  bulks  large.  At  the  will  of  the  individual  the 
banking  system  and  the  security  markets  must  be  prepared 
to  effect  the  desired  readjustment  in  his  investments,  or 
that  resulting  from  changes  in  the  composition  of  the  body 
of  investors.  On  the  other  hand,  the  fluid  capital  held  by 
individual  enterprises  in  the  form  of  demand  deposit 
credits  may  be  said  to  be  now  of  commercial,  now  of  invest- 
ment character.  Such  capital  may  at  times  be  in  excess  of 
the  needs  of  the  enterprises  therefor,  and  the  deposits 
to  the  banking  system  may  appear  instead  to  assume  an 
investment  character.   However,  should  they  be  employed  in 

18  Saving  banks  at  times  in  the  past  are  reported  to  have  done 
this  directly,  United  States  Government  Bonds  being  the  se- 
curities  in   question. 


INVESTMENT    BANKING  123 

the  investment  sphere  by  the  banking  system,  in  the  event 
that  they  are  recalled  by  the  enterprise  for  use  in  the  com- 
mercial sphere,19  such  commercial  demands  will  have 
priority,  and  provision  must  be  made  for  them.20  The  shift 
between  the  two  relations  in  which  such  capital  holdings 
stand  to  the  individual  enterprises  is  of  course  a  corollary 
of  the  status  at  the  time  of  industrial  and  commercial 
activity,  and  at  any  one  moment  determination  of  the  exact 
line  of  demarcation  is  impossible.21  There  is  no  outward 
sign  marking  the  transition  of  such  deposits  from  the 
commercial  to  the  investment  sphere,  nor  likewise  marking 
their  movement  in  the  reverse  direction.  While  its  char- 
acter thus  changes,  the  deposit  outwardly  remains  the  same ; 
the  relationship  of  banking  system  to  depositor  is  unaltered. 
The  same  organization  thus  may  carry  on  both  commercial 
banking  and  investment  banking  at  the  same  time,  and, 
where  the  commercial  banking  principle  is  employed,  under 
the  same  outward  forms  as  respects  the  deposit  aspect. 
The   cleavage  between   investment   banking   and   commer- 

19  The  autumnal  flow  of  funds  from  New  York  and  their  flow 
in  the  reverse  direction  during  the  remainder  of  the  year,  may 
be  cited  as  a  case  in  point.  Thus  the  phenomenon  noted  in  the 
text  may  be  related  to  seasonal  as  well  as  to  cyclic  changes  in 
economic  activity. 

20  In  the  event  of  such  employment,  the  question  of  the  vol- 
ume of  new  saving — either  within  or  without  the  banking  sys- 
tem— available  to  fund  the  same,  arises.  We  pass  here  to  a 
consideration  of  the  investment  aspects. 

21  It  should  be  remarked  that  the  problem  concerns  the  total 
fluid  capital  holdings  of  business  enterprises.  Certain  enterprises 
may  at  any  one  moment  hold  an  amount  considerably  in  ex- 
cess of  their  circulating  capital  requirements,  yet  business  en- 
terprises as  a  whole  hold  roughly  only  the  amount  so  required. 
In  this  event  no  surplus  would  exist  which  could  be  applied 
through   the  banking   system   to   investment   use. 


124  BANKING   THEORY 

cial  banking  then  is  one,  not  of  structure,  but  of  function.22 
We  see  thus  also  that  under  certain  conditions  there  is 
another  factor  in  the  pool  of  investment  financing,  namely, 
the  business  enterprise,  representing  a  group  of  individuals 
and  mediating  as  it  were  between  them  and  the  banking 
system.  This  fact  by  no  means,  however,  alters  the  analysis 
previously  made  of  the  character  of  the  investment  pool  and 
the  role  of  the  various  factors  therein. 

We  turn  now  to  the  reverse  side  of  the  shield,  namely, 
the  investment  aspect.  The  outstanding  feature  is  the 
absence  of  a  direct  and  regular  liquidating  flow  of  com- 
modities in  the  near  future  resulting  from  the  operations 
for  which  the  funds  are  employed,  and  the  consequent 
necessity  of  attaining  in  other  ways  the  requisite  elasticity 
in  the  investment  account,  in  particular  the  potential  de- 
crease of  the  same  to  correspond  with  such  changes  in  the 
deposit  account.  The  adjustment  of  maturities  plays  a 
lesser  role  in  investment  than  in  commercial  banking,  and 
moreover  itself  in  large  part  involves  in  the  former  in  the 
case  of  the  loan  on  securities  merely  shift  to  another  of  the 
burden  of  effecting  the  needed  readjustment.  Separate  analy- 
sis must  be  accorded  the  direct  loan  to  the  business  enter- 
prise, made  prima  facie  for  a  fixed  purpose,  and  the  loan  on 
or  direct  holding  of  securities.  The  direct  loan  to  the  busi- 
ness enterprise  is  in  large  part  a  problem  of  repayment,  as 
is  the  case  in  commercial  banking,  and  an  amortization 
problem  results.23  The  credit  analysis  involved  thus  is 
similar  in  certain  respects  to  that  in  the  case  of  commer- 
cial banking,  where  the  line  of  credit  system  is  employed. 
In  the  case  of  the  loan  on  or  direct  holding  of  securities, 

22  Thus  the  argument  sometimes  made,  as,  e.  g.,  by  Anderson 
and  Moulton,  from  the  statement  of  condition  of  national  banks 
(though  with  respect  to  loans  and  investments),  is  worthless 
in  this  connection. 

23  Cf.   Ch.  V,   Section  3. 


INVESTMENT   BANKING  125 

the  analysis  consists  of  two  parts.  The  analysis  of  the 
general  operations  of  the  business  enterprise  whose  securi- 
ties are  represented,  which  in  the  case  of  commercial  bank- 
ing and  of  the  direct  loan  in  investment  banking,  involves 
an  analysis  of  yield  therefrom  as  affecting  the  power  of  re- 
payment, involves  in  this  case  an  analysis  of  yield  there- 
from as  affecting  the  interest  account,  and  involves  a  study 
rather  of  the  ultimate  safety  of  the  investment.  The  second 
part  concerns  the  shiftability  at  a  given  price  of  the  in- 
vestments held.  This  aspect  of  the  analysis,  while  also 
present  in  commercial  banking  and  the  first  type  of  invest- 
ment banking,  plays  a  lesser  role  therein.  In  commercial 
banking,  as  has  been  remarked  above,  the  question  is 
primarily  one  of  the  internal  organization  of  the  banking 
system.  In  the  case  in  question,  however,  owing  to  the 
feature  of  participation  as  contrasted  with  more  or  less 
temporary  advance,  liquidity  is  attained  through  shiftability. 
Judgment  must  be  reached  as  to  the  amount  of  new  saving 
which  will  be  available  outside  the  banking  system,  as  well 
as  the  amount  which  will  be  available  in  the  same.  While  the 
banking  system  is  responsible  for  effecting  the  readjustment 
desired,  either  in  the  investments  of  the  individual  investor- 
depositor,  or  those  resulting  from  changes  in  the  com- 
position of  the  body  of  investors,  it  can  only  do  so  as  the 
aid  of  individual  investors  is  obtained,  either  within  or 
without    the   banking   system. 

In  large  measure  the  loans  on  securities  will  serve  to 
finance  security  speculation.  This  is  but  a  special  case  of  the 
general  analysis  just  made.  In  the  service  of  speculation  in 
directing  the  flow  of  capital  into  investment,  the  volume 
of  speculation  must  be  adjusted  to  the  investment  demand, 
and  this  in  turn  depends  largely  upon  the  banking  support 
which  is  tendered  such  speculation.  The  questions  here 
raised  parallel  in  considerable  measure  those  indicated  in 
connection  with  commodity  speculation. 


126 


BANKING   THEORY 


It  thus  is  apparent  that  the  problem  which  confronts  the 
individual  unit  and  that  which  confronts  the  investment 
banking  system  as  a  whole  are  similar.  The  question  of  the 
technical  methods  of  operation  of  the  system  cannot  be 
answered  entirely  a  priori,  but  requires  also  a  scientific 
analysis  of  such  empirical  data  as  are  available  at  the  time. 
Considering  investment  banking  merely  as  an  institution, 
there  is  no  reason  to  doubt  that  it,  and  the  pool  of  invest- 
ment financing  of  which  it  is  a  part,  may  operate  entirely 
satisfactorily.24  There  is  no  basic  weakness  inherent  in  it, 
nor  in  commercial  banking.  Both  institutions  thus  may  oper- 
ate entirely  independently  of  each  other.  In  fact,  as  will 
be  seen  from  our  previous  analysis,  investment  banking 
cannot  rely  upon  commercial  banking  for  funds.  Such 
reliance  is  possible  only  if  the  terms  be  considered  in  the 
structural  sense,  and  then  only  insofar  as  time  and  inactive 
demand  deposits  are  held  by  organizations  which  to  a  greater 
or  lesser  extent  do  a  commercial  banking  business.  On  the 
other  hand,  were  business  enterprises  themselves  as  a  whole 
not  to  hold  their  total  circulating  capital  requirements, 
reliance  upon  the  investment  banking  system  for  such  funds 
would  be  possible.  This,  however,  would  involve  a  change 
in  the  methods  of  financing  which  are  now  employed,  and 
commercial  banking  as  we  conceive  it  today,  if  it  did  not 
entirely  disappear,  would  at  least  find  its  field  of  operations 
restricted. 

5.  Opinions  differ  as  to  which  of  the  two  systems  may 
operate  more  satisfactorily.  Underlying  this  difference  of 
opinion  is  difference  in  judgment  as  to  the  relative  technical 

24  It  should  be  noted  that  in  this  discussion  we  do  not  touch 
upon  the  question  as  to  whether  certain  advantages  may  not 
accrue  from  linking  up  investment  banking  and  commercial 
banking  in  certain  particulars.  This  involves  more  detailed 
consideration  of  the  organization  of  the  two  systems,  and  will 
be  considered  in  the  following  chapter. 


INVESTMENT    HANKING  127 

difficulties  inherent  in  the  solution  of  what  is  perhaps  the 
principal  problem  involved  in  the  conduct  of  both  com- 
mercial banking  and  investment  banking,  namely  the 
extent  to  which  loan  and  investment  operations  may  pro- 
ceed with  safety.  From  the  purely  banking  point  of  view, 
the  solution  of  this  problem  depends  in  large  measure 
upon  the  possibility  of  contraction  in  the  volume  of  such 
operations  conducted  by  the  banking  system,  and  disagree- 
ment exists  as  to  the  relative  potential  contractive  power 
which  exists  in  the  two  spheres.  In  our  discussion  of 
commercial  banking,  we  ascribed  it  largely  to  the  self- 
liquidating  power  of  the  commercial  loan.  Certain  writers 
have  denied  the  existence  of  such  liquidity,  and  in  conse- 
quence hold  a  conception  of  banking  radically  different 
from  that  presented  in  the  present  work.  The  argument 
against  the  liquid  character  of  such  loans  points  to  the 
twofold  continuity  in  the  economic  process,  both  (1)  in 
the  operations  of  the  individual  firm,  and  (2)  in  the  inter- 
dependence which  exists  between  the  several  stages  in  the 
economic  process.  It  is  stated  that  "the  business  enter- 
prise in  many  cases,  such  as  in  manufacturing,  whole- 
saling, and  retailing  in  staple  lines,  needs  to  borrow  working 
capital  continuously,"  while  "the  bank  expects  to  tie  itself 
up  more  or  less  permanently  with  its  customers  and  to  ex- 
tend them  continuous  lines  of  credit."-"'  The  period  of  the 
loans,  however,  is  adjusted  to  the  production  period  of  the 
business  enterprise,  and  there  is  thus  potential  liquidity  at 
least  at  the  close  of  the  loans,  even  though  this  involves 
in  some  cases  curtailment  of  the  operations  of  the  enter- 
prise. The  actuality  of  the  liquidation  is  seen  in  the  satis- 
faction in  general  of  the  requirement  of  a  periodic  "clean 
up"  of  the  indebtedness  of  the  business  enterprise.  While 
the  individual  loan  is  not  subject  to  repayment  at  the  will 
25  Moulton,  Commercial  Banking  and  Capital  Formation  III, 
Journal  of  Political  Economy,  Vol.  XXVI,  pp.  707,  718. 


128  BANKING   THEORY 

of  the  lender,  and  hence  may  not  be  realized  upon  at  any 
one  moment,  a  regular  and  continuous  flow  of  maturities 
may  be  arranged,  and  the  value  thereof  is  seen  in  the  fact, 
e.  g.,  that  reliance  is  placed  thereon  to  a  considerable  de- 
gree in  the  operation  of  the  gold  exchange  standard. 
It  should  be  noted  that  as  corollary  of  the  above  view  a  vital 
change  occurs  in  the  conception  of  commercial  banking.  It 
no  longer  represents  a  pooling  of  circulating  capital  sur- 
pluses and  deficits  of  the  totality  of  individual  business  enter- 
prises, but  rather  a  means  of  furnishing  business  enter- 
prises with  permanent  working  capital  which  is  obtained 
from  another  class  in  society.  In  other  words,  it  becomes 
an  investment  process. 

A  further  argument  against  the  self-liquidating  character 
of  the  commercial  loan  is  that  not  only  will  denial  of 
accommodation  result  in  a  curtailment  of  the  activities  of 
the  enterprise  to  which  accommodation  is  denied,  but  that 
there  will  be  an  effect  produced  upon  other  parts  of  the 
economic  process  as  well.  Curtailment  of  the  demand  for  the 
products  of  enterprises  in  preceding  stages  will  result,  as  well 
as  for  articles  in  final  consumption  or  production  form,  as 
the  various  distributive  shares  are  spent  or  invested  by  the 
recipients  thereof,  and  hence  the  passage  of  existing  goods 
through  the  several  stages  in  the  economic  process  will 
cease.  Due  to  this  interdependence  in  the  economic  process, 
disastrous  effects  will  accompany  any  attempts  at  wide- 
spread curtailment  of  accommodation.  This,  however,  is 
primarily  a  problem  of  the  crisis,  and  in  the  investment 
sphere  results  similar  in  many  ways  would  accompany 
attempt  at  widespread  curtailment  of  loans  on  securities. 
It  should  be  noted,  moreover,  that  there  is  a  minimum 
beyond  which  the  curtailment  of  accommodation,  and  hence 
of  industrial  activity,  need  not  extend,  inasmuch  as  a 
considerable  part  of  the  total  number  of  business  enter- 
prises  will   possess   circulating   capital    sufficient    for   their 


INVESTMENT   BANKING  129 

requirements,  although  the  curtailment  of  industrial  activity, 
and  hence  of  demand  for  goods,  may  affect  to  a  different 
extent  the  various  parts  of  the  economic  process. 

While  in  commercial  banking  the  principal  source  in 
obtaining  liquidity  is  conceived  to  consist  of  repayments  by 
recipients  of  funds,  in  investment  banking  liquidity  is  ob- 
tained through  possibility  of  transfer  to  another.  It  is 
obvious  that  this  reputed  shiftability  is  of  importance  only 
in  the  case  of  demand  paper  collateraled  by  securities,  and 
the  present  discussion  will  be  confined  thereto.  In  addi- 
tion to  depreciating  the  liquid  character  of  the  commer- 
cial loan,  attempt  has  been  made  to  establish  the  positive 
superiority  of  the  security  collateral  loan.  A  different 
organization  whereby  capital  is  supplied  exists  in  the  two 
cases,  in  that  in  the  case  of  the  security  collateral  loan 
there  is  an  intermediary  between  banking  system  and  ulti- 
mate recipient  (the  business  enterprise  whose  securities 
are  in  question),  upon  whom  falls  the  burden  of  finding  a 
new  holder.  But  this  does  not  alter  the  fundamental  as- 
pects; if  there  is  not  the  purchasing  power  available  in  the 
market,  lack  of  success  will  be  just  as  certain  in  the  invest- 
ment as  in  the  commercial  sphere,  and  affect  the  banking 
system  equally.  The  existence  of  this  purchasing  power 
in  large  measure  is  dependent  upon  the  area  in  which  the 
evidence  of  supply  of  capital  may  be  disposed  of.  The 
underlying  theory  provides  for  the  obtaining  of  a  market 
broad  enough  so  that  the  withdrawal  of  one  supplier  of 
capital  will  be  compensated  by  the  advent  of  another,  and 
that  the  law  of  averages  thus  may  be  applied.  In  the  case 
of  investment  finance,  there  has  grown  up  a  large  body  of 
direct  suppliers  of  capital  (holders  of  investments)  on  the 
one  hand  (although  these  are  supported  in  considerable 
measure  by  the  funds  of  the  banking  system),  and  on  the 
other  hand  certain  standardized  enterprises,  representing 
but  a  small  part  of  the  total  number  of  business  enter- 


130  BANKING   THEORY 

prises,  which  are  the  ultimate  recipients  of  the  funds. 
Through  this  market  organization,  there  is  rendered  pos- 
sible a  shift  of  securities  from  one  investor  to  another,  and 
the  individual  enjoys  the  advantages  thereof.  In  the  com- 
mercial financing  system,  however,  as  has  been  pointed 
out  above,  the  organization  of  the  several  factors  in  the 
pool  differs,  and  the  individual  bank,  not  the  individual 
enterprise,  bulks  largest;  there  is  a  multitude  of  individual 
borrowers,  with  relative  concentration  in  sources  of  capital 
supply.  The  problem  there  is  one  of  facilities  for  shift- 
ing loans  between  individual  banks ;  otherwise  expressed,  of 
pooling  the  surplus  of  one  bank  with  the  deficit  of  another. 
It  becomes  one  of  the  organization  of  the  banking  sys- 
tem, in  particular  of  the  relationships  existing  between 
individual  banks.  As  will  be  seen  in  the  following  chap- 
ter, the  requisite  cooperation  may  be  effected  in  various 
ways,  most  prominent  among  which  is  by  the  method  of 
rediscounting,  through  the  agency  of  a  central  bank  or  group 
of  banks.  Inasmuch  as  this  is  a  development  which  in 
the  majority  of  cases  represents  a  product  of  evolution  and 
custom  rather  than  an  attempt  at  conscious  change  through 
legislation,  no  reason  exists  for  designating  it  as  "special 
machinery,"  while  holding  that  in  its  absence  the  natural 
organization  prevailing  in  the  case  of  security  collateral 
loans  must  afford  superior  liquidity.26  The  shiftability  of 
commercial  loans  between  individual  banks  provides  a  valu- 
able adjunct  to  the  self-liquidating  character  of  the  oper- 
ations for  which  the  proceeds  of  such  loans  are  employed 
by  the  recipients   thereof.27 

In  last  resort,  the  question  of  the  relative  merits  from 
the  point  of  view  of  liquidity  of  the  commercial  loan  and 

26  Ibid,  pp.  713,  723,  730. 

27  Compare  Stewart's  criticism  of  Anderson,  Journal  of  Politi- 
cal Economy,  Vol.  XXV,  1917,  pp.  996-7. 


INVESTMENT   BANKING  131 

the  loan  collateraled  by  securities  may  be  resolved  in  large 
measure  into  a  question  of  relative  elasticity  of  demand. 
On  the  one  hand,  there  is  the  demand  for  commodities, 
and  the  supply  of  capital  in  the  commercial  banking  sys- 
tem available  for  such  loans ;  on  the  other  hand,  the  de- 
mand for  securities,  as  provided  by  the  combined  funds  of 
individual  investor  and  investment  banking  system.  In  the 
consideration  of  this  question,  a  distinction  is  drawn  by 
Moulton  between  "normal"  times  and  times  of  crisis.28  In 
times  of  crisis  it  is  held  that  nothing  is  liquid,  while  for 
"normal"  times  the  existence  of  lower  rates  on  security 
collateral  loans  is  claimed,  and  is  held  to  attest  superior 
liquidity.  At  the  same  time,  however,  it  cannot  be  denied 
that  greater  inelasticity  off  demand  as  reflected  in  the 
greater  fluctuations  in  rates  charged  for  accommodation 
exists  in  such  periods  for  the  security  collateral  loan,  and 
the  entire  matter  is  by  no  means  clear  cut.  In  any  event, 
there  certainly  does  not  prevail  a  situation  in  which  the 
commercial  loan  conspicuously  lacks  liquidity  at  the  same 
time  that  the  other  type  of  loan  possesses  such  liquidity.  The 
commercial  loan  is  not  a  conspicuous  failure  with  respect 
to  liquidity  in  "normal"  times,  nor  is  the  loan  collateraled  by 
securities  an  outstanding  success  in  times  of  crisis.29 

28  Ibid,  p.  723. 

29  Either  of  these  is  a  logical  prerequisite  to  the  view  of 
Anderson  to  be  noted  below,  and  in  the  absence  of  the  estab- 
lishment of  either,  his  theory  as  to  the  technical  method  of 
operation  of  banking  falls  to  the  ground.  It  should  be  noted 
that  Anderson's  argument  as  to  the  relative  merits  of  the  two 
classes  of  loan  is  confined  practically  to  mere  assertion,  whereas 
Moulton,  while  not  explicitly  going  to  the  same  length  in  his 
general  conclusion,  has  attempted  to  supply  most  of  the  con- 
structive analysis  required.  It  is  interesting  to  trace  the  rela- 
tion of  Moulton's  banking  theory  to  the  specific  problem  which 
he  selects  for  consideration  in  the  series  of  articles  to  which 
reference  has  been  made.     Commencing  with  the  seeming  para- 


132  BANKING   THEORY 

6.  If  the  doctrine  of  the  non-liquidity  of  the  commer- 
cial loan  be  granted,  likewise  the  superiority  of  the  loan  col- 
lateraled  by  securities,  there  is  suggested  as  a  logical  culmina- 
tion the  employment  of  a  liquid  base  of  loans  of  the  second 
class  to  render  possible  the  granting  of  the  first  mentioned 
character  of  accommodation, — in  other  words,  to  regard 
the  second  as  the  smaller  amount  of  current  assets  with 
which  to  support  a  larger  amount  of  relatively  fixed  assets, 
and  thus  to  obtain  the  requisite  margin  of  potential  con- 
traction.30 This  involves  a  well  known  problem  of  bank- 
ing technique,  and  finds  perhaps  clearest  expression  in  cur- 
rent discussion  in  savings  banking  circles.  In  view  of  our 
previous  analysis,  it  is  unnecessary  to  discuss  the  fallacies 
involved  in  this  view,  and  we  may  pass  at  once  to  a  con- 
sideration of  several  other  aspects  of  the  general  theory  of 
banking  which  accompanies  adherence  to  the  doctrine  in 
question.31  First  comes  the  obliteration  of  the  distinc- 
tion between  commercial  banking  and  investment  banking. 
These  are  not  two  separate  though  related  institutions, 
but  there  is  rather  one  institution,  banking;  the  entire 
deposit  structure,  both  demand  and  time,  acts  as  offset  to  the 
entire  loan  and  investment  structure,  although  the  existence 

dox  of  increased  capital  formation  in  a  time  of  increased  con- 
sumption, this  appears  to  him  to  be  rendered  possible  by  uni- 
versal employment  and  consequent  full  productive  activity,  as 
compared  with  the  slack  found  during  the  previous  stage  of  de- 
pression in  the  business  cycle.  Conditions  are  then  favorable 
to  active  demand  for  products,  while  there  is  a  process  of  "pain- 
less" saving  by  the  capitalist  class  from  the  large  returns  it  re- 
ceives. But  to  enable  business  activity,  accommodation  from 
the  banking  system  must  be  readily  available,  and  this  is  limited 
by  the  reserve  position.  Hence,  in  the  elaboration  of  an  accom- 
panying theory  of  banking,  the  creation  of  loanable  funds  on  the 
basis  of  given  cash  reserves  is  stressed. 

30  Foremost  among  protagonists  of  this  view  is  Anderson,  op. 
cit.,  Ch.  XXIV. 


INVESTMENT    BANKING  133 

of  various  types  of  both  deposits  and  loans  and  invest- 
ments must  of  course  be  recognized.  Banking  becomes  a 
structural  category ;  our  interest  lies  in  the  bank.  Its  essen- 
tial feature  consists  in  coining  into  purchasing  power 
either  present  wealth,  that  is,  finished  goods  held  off  the 
market,  or  else  future  prospects.  The  bank  is  a  pawnshop ; 
through  its  application  of  credit  there  is  effected  the 
universalization  of  the  characteristic  of  money,  namely  high 
saleability.32  Through  its  efforts  ever  wider  and  wider  be- 
come the  marvelous  effects  of  the  modern  credit  system. 

We  have  contrasted  with  this  view  the  conception  of  a 
twofold  institution  of  banking,  each  part  of  which  bears  a 
definite  relation  to  the  economic  process.  Commercial  bank- 
ing is  a  means  whereby  there  is  effected  pooling  of  the 
social  circulating  capital,  the  temporary  surplus  of  one  indi- 
vidual business  enterprise  through  it  being  applied  to  the 
temporary  deficit  of  another.  This  pooling  is  effected 
through  mediation  between  buyer  and  seller,  the  latter  being 
the  initial  holder  of  the  deposit  credit,  and  the  successive 
holders  thereof  as  it  is  transferred  supplying  the  offset  to  a 
corresponding  amount  in  the  existing  loan  structure.  The 
deposit  credit  serves  as  a  circulating  medium,  and  we  have 
here  coalescence  of  capital  supply  and  the  currency  sys- 
tem. The  loan  enables  the  buyer  to  obtain  the  good  for  a 
period  of  time  sufficient  to  enable  him  to  pass  the  same 
through  his  stage  in  the  economic  process.  At  the  close 
of  his  production  period  the  good  is  sold,  and  cancella- 

31  It  should  be  noted  that  while  these  other  views  are  corol- 
laries of  the  first  mentioned  doctrine,  acceptance  of  them  by  no 
means  necessarily  implies  acceptance  of  the  latter.  Thus  Moul- 
ton,  while  apparently  ascribing  in  general  to  the  views  which 
follow,  dissents  from  Anderson's  doctrine  of  the  indispensability 
to  the  operation  of  commercial  banking  of  the  loan  collateralcd 
by  securities. 

32  Cf.  Anderson,  op.  cit.,  pp.  475,  591. 


134  BANKING   THEORY 

tion  of  both  loan  and  equivalent  deposit  credit  is  effected. 
These  are  the  essential  features  of  commercial  banking. 
The  institution  of  investment  banking  differs  in  important 
particulars.  In  the  pool  of  investment  financing,  the  indi- 
vidual investor  is  the  lending  unit,  not  the  business  enter- 
prise, and  relative  permanence  of  investment  prevails  with 
respect  to  the  ultimate  recipients  of  funds.  In  this  pool  the 
association  of  those  who  supply  capital,  in  other  words,  the 
institution  of  investment  banking,  plays  a  far  lesser  role; 
the  individual  investor  (including  the  speculator)  bulks 
largest.  In  the  absence  of  the  self-liquidating  feature  found 
in  the  commercial  loan,  it  is  upon  him  that  reliance  is  placed 
in  investment  banking  when  the  depositor  desires  to  with- 
draw from  the  group,  and  this  withdrawal  is  not  com- 
pensated for  by  the  advent  of  another,  while  the  indi- 
vidual investor  thus  likewise  obtains  shiftabality  of  his  in- 
vestment. In  short,  a  different  character  of  cooperation 
is  obtained  in  the  commercial  and  investment  spheres,  and 
obtained  in  a  different  manner.  Functionally,  then,  com- 
mercial banking  and  investment  banking  differ,  and  both 
stand  in  distinctive  relations  to  the  economic  process.  Only 
when  we  recognize  the  distinct  character  of  such  rela- 
tions, and  analyze  them  in  the  above  manner,  can  we  hope 
to  obtain  an  understanding  of  the  institution  of  banking. 


CHAPTER  VII. 

OPERATION    OF   THE   BANKING    SYSTEM 

1.  It  is  evident  from  the  preceding  analysis  that  invest- 
ment banking  is  the  center  of  the  investment  credit  system, 
just  as  commercial  banking  is  the  center  of  the  commercial 
credit  system.  Generalizing,  we  may  say  that  banking  is  the 
center  of  the  credit  system.  But  the  position  occupied  by 
investment  banking  differs  in  some  particulars  from  that 
occupied  by  commercial  banking.  Investment  banking  plays 
no  role  which  corresponds  to  that  played  by  commercial 
banking  in  the  process  of  crediting  and  debiting  the  indi- 
vidual units  for  contributions  made  and  goods  or  services 
received,  and  thus  acting  as  bookkeeper  for  society  with 
respect  to  society's  current  funds.  The  savings  of  individ- 
uals are  not  represented  to  the  same  extent  by  deposit 
credits,  but  by  direct  holding  of  securities  instead.  Rather  is 
the  central  position  occupied  by  investment  banking  evident 
in  its  dispensation  of  credit,  i.  e.,  in  its  loan  and  investment 
operations.  These  present  a  two-fold  aspect.  First  is  the 
selection  of  the  types  of  enterprise  to  which  accommodation 
shall  be  given,  and  the  individual  enterprises  of  each  type. 
Banking  thus  is  not  merely  a  passive,  but  is  instead  an  active 
factor  in  the  economic  process.1  In  the  selective  operation 
the  action  of  commercial  banking  and  investment  banking 
is  substantially  similar,  and  their  position  is  well  recognized.2 

1  It  will  be  observed  that  in  the  previous  analysis,  in  particular 
in  connection  with  commercial  banking,  the  institution  has  been 
considered  largely  as  purely  instrumental. 


136  BANKING   THEORY 

Like  the  entrepreneur,  banking  occupies  a  strategic  position 
with  respect  to  the  course  of  business  activity,  though  exer- 
cising its  control  at  a  somewhat  later  stage  in  the  life  history 
of  the  economic  undertaking.  It  thus  becomes  the  center  of 
the  economic  process  as  well.  The  services  which  it  renders 
include  both  dynamic  control  and  static  mediation.  The 
second  aspect  involves  the  extent  to  which  loan  and  invest- 
ment operations  may  proceed  with  safety.  As  indicated  in 
the  previous  chapter,  this  is  rather  essentially  a  problem  of 
the  estimation  of  the  amount  of  deposit  credits  and  indi- 
vidual savings  (as  a  means  of  disposing  of  securities  held,  as 
well  as  a  source  of  demand  for  securities  which  are  to  pass 
into  the  hands  of  investors)  which  are  available  at  present, 
in  addition  to  their  probable  future  course.  The  question 
becomes,  not  how  much  should  be  loaned,  but  how  much  is 
there  available  to  loan. 

2.  Commercial  financing  and  investment  financing  differ 
in  two  important  respects  in  the  control  which  is  exercised 
in  each  sphere.  The  first  point  of  difference  results  from  the 
homogeneity  which  exists  in  the  one  sphere,  as  contrasted 
with  the  heterogeneity  which  exists  in  the  other.3  This  ren- 
ders unified  control  over  and  direction  of  the  operations  of 
the  first  more  simple  than  in  the  case  of  the  second.  With 
commercial  financing,  control  becomes  a  matter  of  coordi- 
nating the  units  comprising  the  commercial  banking  system, 
and  here  the  approved  method  is  through  a  unification  of 
reserve  holding,  placing  the  same  in  charge  of  a  single  struc- 
tural agency  or  group  of  agencies,  in  the  person  of  a  central 
bank  or  group  of  banks.  This  organization  exercises  control 
over  both  loan  and  deposit  aspects.    In  this  sphere  the  newer 

2  Cf.,  e.  g.,  Anderson,  op.  cit.,  pp.  484  ff ;  Schumpeter,  Theoric 
der  Wirtschaftlichen  Entwicklung,  Leipzig,  1912,  Ch.  Ill;  Som- 
bart,  The  Jews  and  Modern  Capitalism.  Translated  by  M.  Ep- 
stein, London,  1913,  p.  109;  Hawtrey,  op.  cit.,  p.  197. 

3Cf.  Ch.  VI,  Section  1. 


OPERATION    OF   THE   BANKING   SYSTEM  137 

theory  of  the  function  of  reserves  is  fully  developed,  namely, 
to  place  in  central  hands  an  amount  of  liquid  funds  or  claims, 
supplied  by  individual  banks  which  have  a  surplus,  to  be 
applied  to  the  use  of  those  who  are  in  need  of  funds ;  in 
short,  to  obtain  the  most  effective  place  distribution  of  the 
circulating  capital  thus  represented.  The  individual  bank 
which  has  made  a  certain  contribution  to  the  composite  re- 
serve funds  of  the  banking  system  is  entitled  to  control  of 
circulating  capital  to  an  amount  bearing  a  certain  relation 
to  its  contribution,  and  if  it  does  not  already  control  this 
amount,  may  seek  to  obtain  control  of  the  difference  between 
the  amount  and  its  actual  holdings,  as  represented  by  its  de- 
posits. Specie  holdings  operate  merely  as  an  objective  check 
on  too  great  expansion  of  credit,  in  other  words,  as  has  been 
remarked  above,  on  overestimation  of  the  funds  which  are 
available  in  the  hands  of  business  enterprises.  The  bank 
reserve  operates  in  this  manner,  rather  than  as  a  means  of 
redeeming  deposits  in  objective  wealth,  which  represents  the 
original  conception  of  reserves,  and  which  caters  to  man's 
psychologic  reluctance  to  part  with  a  good  without  absolute 
assurance  of  what  he  regards  as  an  equivalent  return.  With 
reference  to  the  loan  aspect,  through  its  position  as  a  source 
of  supply  of  funds  to  individual  banks  which  are  "loaned 
up,"  the  central  bank  is  enabled  to  select  both  the  type  of 
enterprise  and  the  specific  individual  enterprises  of  each 
type  to  which  accommodation  will  be  granted.  Its  selective 
activity  is  confined  basically  rather,  however,  to  the  marginal 
enterprise  than  to  the  entire  rank  and  file  of  enterprises, 
although  special  measures  such  as  the  rationing  of  credit 
may  be  taken  to  control  the  entire  field.4  In  the  case  of 
investment  banking  no  such  relative  simplicity  exists,  and 
the  matter  resolves  itself  rather  into  two  separate  problems : 

4  The  technical  methods  whereby  control  is  exercised,  in  par- 
ticular the  discount  rate,  are  beyond  the  scope  of  the  present 
work,  and  their  operation  and  efficacy  will  not  be  discussed. 


138 


BANKING   THEORY 


(1)  the  control  which  is  exercised  by  one  part  of  the  pool  of 
investment  financing  over  another  part,  and  (2)  the  control 
which  is  exercised  within  each  part.  These  we  shall  consider 
presently. 

Commercial  financing  and  investment  financing  differ  also 
in  the  effectiveness  of  the  control  which  may  be  exercised 
over  the  directions  which  capital  investment  shall  take,  due 
to  the  difference  in  the  fundamental  nature  of  the  two  pools. 
The  control  which  is  exercised  in  commercial  financing 
may  be  far  more  drastic  in  its  effects,  as  well  as  more  rapidly 
carried  out.  Due  to  the  self-liquidating  character  of  the 
operations  to  which  the  capital  is  applied,  it  would  be  possible 
to  change  the  composition  of  industrial  activity  within  a 
relatively  short  period.  The  extent  to  which  this  could  be 
done  would  of  course  be  limited  by  the  fact  that  it  would 
be  necessary  to  employ  the  existing  fixed  capital  equipment 
in  conjunction  with  the  circulating  capital.  Application  of 
the  circulating  capital  in  totally  new  directions  would  be  pos- 
sible only  insofar  as  new  capital  in  the  other  sphere  is  ap- 
plied in  new  channels,  and  the  existing  equipment  is  diverted 
and  adapted  to  other  types  of  operations  than  those  for 
which  it  was  originally  constructed.  In  the  case  of  invest- 
ment financing,  the  effect  upon  the  composition  of  the  indus- 
trial world  would  be  worked  out  with  respect  to  the  part 
employed  as  fixed  capital,  first  through  the  direction  of  the 
increments  of  new  capital  into  different  channels,  and  thus, 
mathematically  speaking,  instead  of  changing  x,  through 
changing  dx,  and  second  through  change  in  the  equipment 
designed  to  replace  existing  equipment  as  the  latter  is  dis- 
carded. The  second  form  is  of  course  under  the  control  of 
the  business  enterprise.  While  this  difference  in  effective- 
ness of  control  between  commercial  financing  and  investment 
financing  is  of  no  consequence  where  a  positive  mistake  in 
judgment  has  been  made  by  the  banking  system,  it  is  of  im- 


OPERATION   OF  THE   BANKING   SYSTEM  139 

portance  where  it  is  desired  rather  to  anticipate  and  control 
the  situation  which  is  to  exist  in  the  future. 

To  turn  now  to  the  several  elements  in  the  pool  of  invest- 
ment finance.  As  remarked  in  the  previous  chapter,  we 
must  distinguish  first,  the  advance  of  capital  represented  by 
the  direct  loan  to  the  business  enterprise,  and  second,  that 
represented  by  the  security,  either  bond  or  share,  including 
the  advance  made  to  a  holder  thereof.  Where  it  makes  ad- 
vances of  the  first  type,  the  investment  banking  system 
comes  directly  in  contact  with  the  business  enterprise.  In 
the  pool  of  investment  financing  the  process  of  capital  supply 
in  general,  however,  involves  a  succession  of  intermediaries. 
For  the  present  purpose,  we  may  consider  these  to  be  repre- 
sented structurally  by  first,  the  trader  in  securities,  second 
the  speculator,  who,  however,  may  be  eliminated,  and  is  one 
step  removed  from  the  third,  the  individual  investor  and  the 
bank.5  In  the  process  of  capital  supply,  or,  as  it  appears, 
when  viewed  in  the  reverse  manner,  of  passing  securities 
from  one  stage  to  another,  the  element  in  each  stage  decides,6 
on  the  one  hand,  in  what  manner  to  apportion  funds  to  dif- 
ferent types  of  industry,  and  to  different  enterprises  of  each 
type,  while,  on  the  other  hand,  it  judges  the  amount  of  capi- 
tal in  the  form  both  of  individual  savings  for  direct  invest- 
ment and  of  deposits,  available  for  investment.    While  the 

5  It  will  be  observed  that  the  classification  differs  somewhat 
from  that  given  in  Chapter  VI,  Section  1.  Under  the  term 
"bank"  may  be  included,  in  addition  to  the  bank  having  inactive 
demand  or  time  deposits  and  the  savings  bank,  also  the  insur- 
ance company  conducted  upon  the  actuarial  principle  of  reserves 
and  the  cooperative  bank.  It  will  be  apparent,  however,  that 
the  major  part  of  the  analysis  which  follows  in  the  text  applies 
to  the  first  alone. 

6  Though  the  emphasis  of  course  differs  somewhat,  and  cer- 
tain elements  may  consider  rather  one  aspect  than  the  other. 
Thus  saving  banking  is  concerned  rather  with  the  gathering 
than  the  supply  of  capital. 


140  BANKING   THEORY 

individual  investor  and  the  bank,  acting  as  "consumers"  of 
securities,  are  thus  the  ultimate  judges  of  the  types  of  indus- 
try to  which  accommodation  will  be  extended,  and  the 
amount  of  securities  must  be  adjusted  to  the  funds  which 
they  possess,  at  each  successive  stage  judgment  is  passed 
on  the  given  operation  by  the  element  in  that  stage.  Each 
successive  intermediary  controls  those  who  precede.  But 
the  intermediaries  in  the  process,  as  is  well  known,  do  not 
operate  entirely  with  capital  which  they  themselves  possess, 
and  look  instead  to  the  banking  system  as  a  source  of  supply. 
This  then  enables  a  more  direct  contact  by  the  banking  sys- 
tem, and  a  more  direct  control  by  it  of  each  stage  in  the 
process.  Instead  of  entering  merely  at  the  close  of  the  pro- 
cess of  capital  supply,  it  reaches  well  toward  the  commence- 
ment also.  It  thus  can  make  the  influence  of  its  judgment 
promptly  felt,  instead  of  merely  when  the  securities  in  ques- 
tion are  offered  to  it  for  purchase,  and  thus  can  prevent 
commitments,  rather  than  merely  reject  commitments  already 
made.  It  thus  also  is  enabled  to  exercise  control  over  a 
wider  area  of  the  pool  of  investment  financing  than  were  it 
confined  to  its  relatively  small  role  as  a  purchaser  of  securi- 
ties. Not  only  does  it  exercise  this  more  widespread  control 
directly,  through  loans  to  traders  in  securities,  but  also  in- 
directly through  loans  to  speculators,  and  thus  it  avails  it- 
self of  the  influence  which  speculation  in  turn  exercises  in 
"directing  the  flow  of  capital  into  investment."  The  control 
which  it  exercises  over  one  part  reinforces  the  control  which 
it  exercises  over  another.  The  situation  in  the  pool  of  invest- 
ment financing  which  has  just  been  described  may  be  dia- 
grammatically  represented  as  follows : 7 

7  Abstraction  has  been  made  from  direct  offering  of  securities 
to  the  investor  by  the  business  enterprise  itself,  as  well  as  from 
intervention  by  several  intermediaries  of  the  same  general  type. 


OPERATION   OF   THE   BANKING   SYSTEM 


141 


INDIVIDUAL 
INVESTOR 


INVESTMENT 

BANKING 

SYSTEM 


TRADER  IN 
SECURITIES 


BUSINESS 

ENTERPRISE 


Key : — loan ; purchase  of  securities 

Practically,  then,  the  ultimate  responsibility  for  the  direc- 
tion of  the  pool  of  investment  finance  falls  upon  the  invest- 
ment banking  system,  which  becomes  its  overseer.  Our 
second  problem  then  narrows  down  to  the  consideration  of 
the  control  exercised  within  the  investment  banking  sphere. 
We  note  at  once  the  absence  of  definite  organization  to  this 
end.  Due  in  part  to  the  market  for  the  investments  held 
which  is  afforded  by  the  security  market,  as  described  in  the 
previous  chapter,  the  need  for  a  centralized  reserve  holder 
has  not  been  felt  insofar  as  a  considerable  part  of  the  assets 
has  been  invested  in  well-known  and  listed  securities.  In 
fact,  it  is  found  that  the  reserve  organization  of  the  invest- 
ment banking  system  is  far  inferior  to  that  existing  in  the 
case  of  the  commercial  banking  system.  The  underlying 
reserve  theory,  in  particular  in  connection  with  the  savings 
deposit  and  time  deposit,  may  be  termed  the  "available  fund" 
theory  of  reserves,  where  the  reserve  consists  of  a  supply  of 
demand  deposit  credits  on  the  books  of  the  commercial  bank- 
ing system,  rather  than  the  modern  conception  found  in  oper- 
ation in  commercial  banking  today.  The  application  of  the 
modern  reserve  theory  in  the  sphere  of  investment  banking 
would  involve  not  merely  a  coordination  of  deposits  in  order 
to  render  excess  funds  in  one  part  of  the  system  available  to 
meet  deficits  in  other  parts,  but  would  also  involve  taking 


142  BANKING   THEORY 

over  part  of  the  investments  of  individual  units,  and  thus  the 
exercise  of  selective  power  over  the  enterprises  to  be 
financed.8  In  investment  banking,  however,  the  danger  of 
non  liquidity  of  assets,  in  the  form  of  potential  liquidation  by 
ultimate  recipient  of  funds,  is  more  pronounced  than  in  com- 
mercial banking.  This  means  that  in  this  sphere  the  device 
serves  to  obtain  more  effective  place  distribution  of  existing 
capital,  rather  than  to  cope  with  a  decrease  in  the  amount  of 
capital  available.  Thus  it  is  thought  necessary  also  to  "fund" 
the  investments  which  the  reserve  holder  takes  over  from  the 
individual  units.  Where  attempt  has  been  made  to  coordi- 
nate special  parts  of  the  investment  banking  system,  such  as 
in  connection  with  rural  credits,  or  with  the  War  Finance 
Corporation  in  certain  of  its  aspects,  a  funding  has  at  once 
been  provided  of  the  investments  taken  over  by  the  central 
organization,9  through  sale  of  the  organization's  own  obliga- 
tions to  individual  investors,  rather  than  an  attempt  made 
subsequently  to  turn  the  investments  over  to  individual  units 
which  are  in  possession  of  surplus  funds.  It  should  be  noted 
also  that  the  device  is  found  rather  in  connection  with  securi- 
ties which  are  less  standardized  and  do  not  command  as 
ready  a  market.  It  is  here  rather  that  the  need  for  such 
organization  has  been  apparent.  A  modification  of  the  gen- 
eral form  of  control  just  sketched  is  found  in  the  case  of  the 
Money  Pool,  the  purpose  of  which  was  to  provide  through 

8  As  the  individual  banks  thus  supply  the  reserve  funds  with 
which  the  reserve  holders  operate,  it  cannot  be  stated,  as  Haw- 
trey,  op.  cit,  p.  205,  does,  that  "statutory  reserve  proportions 
...  no  longer  serve  any  useful  purpose." 

9  While  the  operating  principle  (sale  of  own  obligations  col- 
lateraled  by  other  securities,  or  sale  of  these  securities  with  en- 
dorsement), is  the  same  as  in  the  case  of  one  of  the  forms  of 
trading  in  securities,  the  central  organization  enters  at  a  later 
stage  in  the  process  whereby  securities  are  passed  into  the  hands 
of  investors. 


OPERATION    OF   THE    BANKING    SYSTEM  143 

the  cooperation  of  lenders  a  supply  of  funds  for  speculative 
dealings  in  stock  exchange  securities,  while  at  the  same  time 
controlling  both  the  volume  and  character  of  such  dealings. 

Aside  from  the  control  exercised  in  the  ordinary  course 
of  business  operations — in  connection  therewith  and  incident 
thereto — such  as  has  just  been  described,  there  is  also  what 
may  be  termed  external  control.  This  has  two  forms.  The 
work  of  the  Capital  Issues  Committee  during  the  war  repre- 
sents an  attempt  both  to  select  from  among  different  indus- 
tries and  to  limit  the  total  amount  to  the  amount  of  capital 
available  for  the  purpose,  although  not  concerned  with  the 
gathering  of  this  capital.  At  the  same  time,  the  control  is 
exercised  at  the  commencement  of  the  financing  process,  and 
thus  undesirable  investment  is  prevented.  This  form,  how- 
ever, with  its  drastic  regulation,  is  an  emergency  measure 
only.  The  second  form  of  control  is  that  represented  by  the 
"blue  sky"  legislation  of  various  states,  and  the  examination 
by  the  organized  exchanges  of  securities  offered  for  listing 
at  these  exchanges.  Measures  of  this  kind,  however,  have 
but  one  primary  purpose — the  selection  of  securities  which 
are  of  a  sufficiently  high  calibre,  and  thus  to  afford  certain 
minimum  safeguards  to  the  investor.  No  attempt  is  made 
to  judge  the  amount  of  new  capital  available,  nor  to  check 
attempted  overdevelopment  in  certain  lines  of  enterprise. 
The  aim  becomes  merely  the  elimination  of  the  wildcat  se- 
curity, and  this  method  must  therefore  play  but  a  negligible 
role  in  the  present  analysis. 

3.  As  banking  is  the  center  of  both  the  pool  of  commer- 
cial financing  and  the  pool  of  investment  financing,  and  con- 
trols each,  a  consideration  of  the  relationship  between  the 
two  pools  with  respect  to  the  general  problem  of  control  re- 
solves itself  into  a  consideration  of  such  relations  between 
commercial  banking  and  investment  banking.  Two  separate 
phases  must  be  recognized,  namely  the  problems  involved 
and  the  methods  of  solution.     The  two  problems  indicated 


144  BAN  KIM  G   THEORY 

above  concern  themselves  with  (1)  coordination  of  the  selec- 
tive activities  of  commercial  banking  and  investment  bank- 
ing, as  well  as  the  check  which  each  exercises  upon  the  other, 
and  (2)  apportionment  to  each  use  of  that  part  of  the  total 
funds  which  it  is  judged  is  available  in  that  sphere.    For  the 
present  purpose,  each  of  these  two  problems  must  be  con- 
sidered separately,  although  in  our  discussion  of  control  with- 
in each  sphere,  the  same  agency  was  regarded  as  controlling 
with  respect  to  both  problems.    Turning  to  the  first  problem, 
it  will  be  remarked  that  investment  banking  "checks"  the 
individual  transactions  of  business  enterprises  upon  which 
the  commercial  banking  system  has  set  its  seal  of  approval 
only  through  the  consumers'  demand  which  it  furnished  for 
the  production  goods  so  produced.    Where  permanent  capi- 
tal equipment  has  once  been  raised  for  the  business  enter- 
prise, however,  subsequent  requirements  for  circulating  capi- 
tal afford  opportunity  for  commercial  banking  to  check  the 
judgment  previously  reached  in  the  investment  sphere.  Thus 
the  structural  agency  which  controls  in  the  commercial  sphere 
is  enabled  in  this  manner  at  will  to  extend  its  control  over 
the  investment  sphere.   But  this  may  be  a  wasteful  process, 
and  coordination  of  the  selective  activities  of  both  would 
appear  desirable  to  avoid  misdirection  of  productive  activity. 
In  order  to  attain  maximum  efficiency,  the  control  in  the 
investment   sphere,   moreover,   should  be  primarily  at   the 
source  and  should  concern  itself  with  loans  to  houses  en- 
gaged in  the  process  termed  above  "commerce  in  securities." 
This  control  by  investment  banking  should  be  "linked  up" 
with  the  control  in  the  commercial  sphere.     In  actual  fact, 
such  is  now  the  case.    The  individual  so-called  "commercial 
bank"  engages  in  both  commercial  and  investment  banking, 
in  the  latter  in  the  operations  just  noted,  and  through  this 
fact,  symmetry  of  credit  extension  in  the  two  spheres  may 
be  obtained.    Both  repress  the  same  lines  of  activity,  while 


OPERATION    OF   THE   BANKING   SYSTEM  145 

at  the  same  time  encouraging  other  lines.  By  this  means, 
the  controlling  agency  in  the  commercial  sphere  may  also  in- 
directly exercise  control  over  the  investment  sphere. 

The  fact  that  the  same  organizations  engage  in  both  com- 
mercial banking  and  investment  banking,  in  particular  those 
operations  which  directly  control  the  entire  pool  of  invest- 
ment financing,  has  an  important  effect  upon  the  problem 
of  the  control  which  is  exercised  in  the  apportionment  of 
funds  to  the  two  uses.10  This  structural  cleavage,  and  the 
fact  that  both  commercial  banking  and  investment  banking 
obtain  by  means  of  the  deposit  principle  the  funds  with 
which  they  operate,  has  tended  to  obscure  the  broad  under- 
lying function  of  the  pool  of  investment  financing  as  con- 
trasted with  the  pool  of  commercial  financing,  and  the  role 
of  investment  banking  therein,  and  has  caused  investment 
banking  to  be  regarded  rather  as  an  appendix  to  commercial 
banking.  As  we  have  seen,  in  commercial  banking  alone  is 
there  a  high  degree  of  organization ;  where  found  at  all  in 
investment  banking,  it  is  confined  to  special  parts  of  the  field. 
Two  alternatives  are  thus  open  as  to  the  form  which  the 
organization  of  the  investment  banking  system  in  relation 
to  the  commercial  banking  system  may  take.  Its  reserves 
may  be  either  uncentralized,  or  they  may  be  concentrated  in 
the  central  reserve  holder  for  the  commercial  banking  sstem, 
which  in  fact  is  the  case  when  such  organization  of  the  com- 
mercial banking  system  prevails.  Were  it  desired  to  employ 
these  investment  banking  reserves  per  se,  funding,  as  we 
have  seen,  would  be  regarded  as  necessary,  but  this  would 
serve  to  introduce  another  and  different  operating  principle 
in  the  conduct  of  the  affairs  of  the  central  reserve  holder. 
Its  business  would  then  appear  rather  heterogeneous,  and  in 
fact  this  combination  is  not  found  in  existence  today.  Thus 
the  reserves  of  the  investment  banking  system  are  concen- 

10  As   remarked  in   Ch.  VI,  Section   4,  the  problem   concerns 
funds  available  outside  the  banking  system  as  well  as  within. 


146  BANKING   THEORY 

trated  in  the  central  reserve  holder  for  the  commercial  bank- 
ing system,  and  do  not  perform  directly  their  basic  function. 
The  Federal  Reserve  banks  hold  the  reserves  of  member 
banks  (13,  10,  and  7  per  cent)  against  inactive  demand  de- 
posits which  are  practically  of  investment  nature,  and  the  3 
per  cent  reserves  against  time  deposits,  yet  these  funds  may 
not  be  applied  directly  for  investment  use.11  Objectively 
viewed,  they  appear  to  represent  rather  an  application  of  the 
"available  fund"  theory  of  reserves  considered  above,  in- 
vestment banking  thus  possessing  certain  deposit  credits  on 
the  books  of  the  commercial  system,  against  which  there 
is  as  offset  loans  made  in  the  commercial  sphere.  In  order 
to  facilitate  the  operation  of  the  investment  banking  system, 
investors  thus  supply  to  business  enterprises  part  of  the  cir- 
culating capital  which  these  enterprises  require,  and  to  this 
extent  the  commercial  banking  system  loses  the  cooperative 
aspect  which  is  one  of  its  outstanding  characteristics.  It 
should  be  noted,  however,  that  because  of  the  conduct  of 
both  classes  of  banking  by  the  same  organization,  the  central 
reserves  are  available  to  it  in  the  event  of  withdrawal  of  a 
deposit  and  non-curtailment  of  investments  to  correspond, 
through  borrowing  by  means  of  its  previous  commercial 
loans,  either  in  the  form  of  rediscount  with  or  bills  payable 
to  the  central  reserve  holder.  Assuming  that  the  funds  rep- 
resented by  the  investment  deposit  withdrawn  had  been  in- 
vested or  loaned  for  a  fixed  purpose,  the  offset  to  this  invest- 
ment or  loan  must  be  a  part  of  the  investment  reserves 
possessed  by  the  central  reserve  holder,  while  at  the  same 
time  the  demand  deposits  of  the  individual  bank  obtaining 
the  accommodation  act  as  offset  to  its  former  commercial 
loans,  which  are  now  in  the  possession  of  the  central  reserve 
holder.12     The  extent  to  which  this  may  be  done  is  thus 

11  Abstraction  is  made  in  the  discussion  which  follows  from 
loans  on  United  States  government  obligations. 


OPERATION    OF  THE   BANKING   SYSTEM  147 

limited  to  the  amount  of  investment  reserves,  although 
through  misj  udgment,  here  as  in  other  parts  of  banking,  this 
limit  may  be  exceeded.  This  method  of  utilization  of  the 
reserves  of  course  requires  that  a  sufficient  amount  of  com- 
mercial paper  acceptable  to  the  central  reserve  holder  be  in 
the  hands  of  the  individual  bank ;  but,  viewing  the  system  as 
a  whole,  and  the  small  proportion  of  total  deposits  concen- 
trated in  the  reserve  holding  organization,  it  would  appear 
that  no  difficulty  should  be  experienced.  In  actual  practice, 
then,  the  reserves  are  centralized  in  the  commercial  banking 
system.  The  central  reserve  holder  exercises  control  over 
the  process  as  a  whole,  but,  due  to  the  indirect  access  to  the 
investment  reserves  which  is  permitted,  control  over  the  ap- 
portionment of  funds  to  the  two  uses  is  possible  only  insofar 
as  there  is  direct  ascertainment  of  the  reasons  underlying  the 
request  for  accommodation  by  the  individual  bank,  and  direct 
refusal  to  accede  to  the  request  is  made  when  deemed  appro- 
priate. 

The  view  in  general  prevails  that  provision  is  made  in  this 
organization  of  reserves  and  method  of  operation  for  giving 
commercial  financing  priority  over  investment  financing,  i.  e., 
for  permitting  such  loans  to  be  made  to  any  extent  desired, 
as  against  undertaking  investment  operations.  As  we  have 
just  seen,  however,  there  is  no  royal  road  in  the  apportion- 
ment process,  and  the  matter  is  entirely  one  of  judgment  on 
the  part  of  individual  bank  and  central  reserve  holder.  But 
let  us  consider  the  current  view  at  somewhat  greater  length. 
In  the  Federal  Reserve  system,  priority  for  commercial 
financing  would  extend  to  the  investment  reserves,  which 
would  be  available  for  application  to  commercial  needs,  and 

12  A  similar  analysis  holds  when  borrowing  from  the  central 
reserve  holder  occurs  in  order  to  make  additional  fixed  loans 
or  investments.  Thus  member  banks  are  reported  to  have  re- 
discounted  with  Federal  Reserve  banks  and  placed  the  proceeds 
in  call  loans  in  New  York  some  time  ago. 


148  BANKING   THEORY 

part  of  the  circulating  capital  requirements  of  business  en- 
terprises supplied  from  the  permanent  .capital  of  savers. 
By  this  means,  the  train  of  reasoning  runs,  a  cardinal  diffi- 
culty, namely  overinvestment  and  sinking  of  capital  in  fixed 
as  against  circulating  uses,  is  avoided.  On  the  other  hand, 
a  limitation  also  exists  to  the  process  of  granting  accommo- 
dation for  circulating  uses.  Within  rough  limits,  more  than 
a  certain  amount  of  circulating  capital  cannot  be  used  in 
conjunction  with  a  given  amount  of  fixed  capital.  This  bal- 
ance, as  it  may  be  termed,  between  fixed  and  circulating  capi- 
tal, is  rather  a  long  run  phenomenon,  and  represents  one 
application  of  the  general  theory  of  economic  equilibrium,  as 
well  as  of  what  has  been  termed  the  law  of  proportionality, 
which  represents  the  first  method  by  which  the  equilibrium 
is  effected.  Other  equilibria  are  also  in  process  of  establish- 
ment. Shifting  to  the  real  level  of  the  analysis,  the  balance 
between  fixed  and  circulating  capital  means  a  balance  be- 
tween the  amount  of  goods  (of  whatever  description)  in  pro- 
cess of  manufacture,  and  the  fixed  capital  equipment  of  so- 
ciety. The  balance  between  the  two  kinds  of  capital  is 
largely  effected  through  changes  in  the  two  kinds  of  finished 
goods  produced,  namely  those  destined  for  use  as  final 
consumption  goods  and  as  finished  active  production  goods, 
abstraction  being  made  for  this  purpose  from  goods  em- 
ployed as  passive  production  goods,  which  ultimately  emerge 
from  the  economic  process  in  one  of  the  other  two  forms. 
This  then  requires  a  corresponding  balance  between  saving 
and  consumption,  inasmuch  as  long  continued  investment 
operations  calling  for  goods  destined  to  serve  as  fixed  capi- 
tal will  not  be  undertaken  in  the  absence  of  a  consumptive 
demand  for  the  products  of  such  capital  goods,13  and  repre- 

13  This  point  has  been  indicated  by  Moulton,  Commercial 
Banking  and  Capital  Formation,  IV,  Journal  of  Political  Econ- 
omy, Vol.  XXVI,  1918,  pp.  853  ff.,  879. 


OPERATION    OF   THE   BANKING   SYSTEM  149 

sents  the  second  method  in  which  the  general  equilibrium  is 
effected. 

The  equilibrium,  however,  acts  as  a  limiting  factor  in  pre- 
venting excessive  application  of  funds  to  fixed  as  against 
circulating  uses,  or,  otherwise  phrased,  of  overestimation  of 
funds  available  in  the  investment  as  against  the  commercial 
sphere.  A  second  limiting  factor  is  seen  in  considering  the 
operations  of  the  individual  bank  as  contrasted  with  the 
banking  system  as  a  whole,  for  it  can  ill  afford  to  attempt  to 
maintain  a  disproportion  between  the  character  of  assets  and 
liabilities  in  the  form  of  an  excess  of  active  demand  deposits 
over  commercial  loans,  relying  upon  deposits  of  an  invest- 
ment nature  found  elsewhere  in  the  banking  system  to  offset 
its  own  investment  operations.14  In  actual  practice,  the 
necessity  for  regular  substitution  of  new  commercial  paper 
as  maturities  approach,  will  also  act  as  a  deterrent.  As  a 
corollary  of  the  equilibria  just  mentioned,  which  exist  in  the 
business  world,  there  arises  for  banking  the  possibility  of 
controlling  the  volume  of  commercial  operations  through  the 
control  exercised  over  the  volume  of  investment  financing, 
and  vice  versa.  Lack  of  extension  of  investment  banking 
accommodation  limits  the  volume  of  commercial  transac- 
tions arising  from  such  operations,  and  hence  the  demand 
by  recipient  enterprises  for  commercial  banking  accommoda- 
tion, assuming  that  the  capital  received  by  such  enterprises 
be  employed  for  fixed  purposes,15  as  well  as  the  demand  for 
commercial  banking  accommodation  by  further  purchasers 
of  the  goods  created  with  the  original  capital,  while,  on  the 
other  hand,  limitation  of  commercial  banking  accommoda- 
tion restricts  employment  of  existing  equipment  and  may 

14  The  equilibrium  thus  acts  as  a  limiting  factor  in  connec- 
tion with  the  similar  problem  which  confronts  the  individual 
bank,  considered  in  Ch.  VI,  Section  4. 

15  Cf.  Moulton,  Commercial  Banking  and  Capital  Formation, 
III,  Journal  of  Political  Economy,  Vol.  XXVI,  1918,  p.  728. 


150  BANKING   THEORY 

well  cause  hesitancy  in  undertaking  new  fixed  investment. 

An  additional  mechanical  aid  exists  for  use  in  estimating 
the  amount  of  funds  available  for  investment  and  for  com- 
mercial use,  namely  the  requirement  of  departmentaliza- 
tion and  segregation  of  time  and  savings  deposits  received 
by  organizations  which  also  conduct  commercial  banking 
operations.  The  limited  applicability  of  this  device  will  be 
evident  from  the  above  exposition,  inasmuch  as  it  does  not 
include  inactive  demand  deposits  which  are  in  the  "twilight 
zone." 

4.  There  are  certain  limitations  upon  the  extent  to  which 
loan  and  investment  operations  may  be  engaged  in,  which  be- 
come operative  through  the  effect  produced  when  attempt  is 
made,  wilfully  and  consciously,  or  otherwise,  to  disregard 
them.  Differently  pharased,  there  are  forces  which  work  to 
keep  banking  within  the  straight  and  narrow  path.  The 
traditional  effect  is  that  upon  prices,  which  presents  a  two- 
fold aspect,  being  either  general,  or  confined  instead  to  par- 
ticular commodities.  The  first  is  related  to  estimation  by 
the  banking  system  of  the  total  funds  available,  the  second 
to  selection  from  among  applicants  for  accommodation.  No 
attempt  of  course  will  be  made  to  do  more  here  than  to 
sketch  the  principal  features,  and  no  theory  of  general  prices 
is  advanced,16  it  being  sufficient  for  the  purpose  at  hand 
to  take  the  objective  fact  that  a  considerable  increase  in  the 

16  The  quantity  theory  by  no  means  is  assumed.  The  reason- 
ing as  to  casual  relations  in  the  price  fixing  process,  for  exam- 
ple, might  proceed  broadly  along  the  following  line,  employing 
an  absolute  concept  of  value:  Credit  is  easier  to  obtain,  hence 
the  value  of  the  individual  unit  (expressed  in  terms  of  and 
equal  to  the  monetary  unit),  decreases,  whereas  the  value  of 
the  individual  unit  of  commodities  remains  unchanged.  Or  the 
fact  of  the  employment  of  money  in  the  purchase  of  commodi- 
ties may  be  further  introduced,  and  the  argument  explicitly  car- 
ried to  its  logical  conclusion,  money  thus  declining  in  value  rela- 
tive to  other  commodities. 


OPERATION    OF   THE   BANKING   SYSTEM  151 

volume  of  the  purchasing  media,  in  the  absence  of  increased 
business  activity  which  does  not  result  from  placing  these 
media  in  the  hands  of  prospective  purchasers,  is  accompanied 
by  (and  accompanies)  some  increase  in  general  prices.17 
The  conventional  doctrine  relative  to  the  proper  conduct  of 
banking  is  to  the  effect  that  the  total  original  extension  of 
credit,  both  loans  and  investments,  shall  not  be  in  excess  of 
the  available  goods  coming  on  the  market,  which,broadly, 
equals  the  deposit  credits  available.  There  is  thus  no  bid- 
ding by  the  recipient  of  funds  from  the  banking  system 
against  depositors  who  desire  to  convert  their  deposits  into 
goods.18  But  the  process  of  overestimation  of  the  total 
funds  available  in  general  will  be  reflected  more  particu- 
larly in  the  accommodation  extended  to  certain  particular 
types  of  enterprises  believed  to  be  in  a  peculiarly  favorable 
position.  Overextension  of  credit  in  fact  may  be  confined 
merely  to  certain  particular  classes  of  business  activity,  and 
general  overextension  (or  overestimation)  be  entirely  absent. 
Where  this  is  the  case  rather  than  general  overextension,  in 
commercial  banking  the  course  of  the  prices  of  the  commodi- 
ties produced  by  the  industries  in  question  tends  to  be  the 
reverse  of  the  course  of  general  prices  in  the  event  of  general 
overextension,  although  the  tendency  may  be  submerged  in  a 
period  of  increasing  business  activity.  Overextension  in  spe- 
cial industries,  it  should  be  noted,  itself  tends  to  an  increase 
in  general  prices  through  the  employment  of  the  funds  both 
in  purchases  of  raw  materials,  etc.,  and  in  purchases  by  wage 
earners.  In  investment  banking  there  is  a  similar  effect, 
the  prices  of  the  capital  goods  required  tending  to  increase, 
while  the  "price"  of  the  enterprise  itself  tends  to  decrease. 

17  Although  the  entire  matter  may  be  regarded  as  a  currency 
problem,  we  shall  confine  our  attention  primarily  to  price 
changes  in  their  relation  to  banking. 

18  The  problem  thus  is  seen  to  involve  also  the  activity  of 
accounts. 


152  BANKING    THEORY 

Overestimation  of  the  total  funds  available  may  be  of  sev- 
eral kinds.  It  may  occur  in  both  commercial  and  invest- 
ment spheres,  or  merely  in  either  one,  and,  due  to  the  struc- 
tural combination  of  classes  of  business  remarked  in  the 
preceding  section,  may  appear  to  show  attempted  encroach- 
ment by  the  investment  banking  system  upon  funds  properly 
belonging  to  the  commercial  banking  system.19  Due  to  the 
difference  in  relative  permanence  of  application  of  capital 
in  the  two  spheres,  there  is  an  important  difference  in  the 
flexibility  of  adjustment  to  decrease  in  the  total  volume  of 
funds  available.  Assuming  neither  general  nor  widespread 
price  revulsion,  nor  misjudgment  in  the  particular  loan  oper- 
ations, with  commercial  banking  readjustment  in  the  event 
of  what  appears  to  be  a  too  heavy  extension  of  original  loans 
in  certain  particular  lines  may  be  effected  through  curtail- 
ment of  loan  operations  as  existing  loans  are  repaid.  In  the 
case  of  investment  banking,  however,  the  situation  is  not  so 
simple.  The  nearest  approach  to  that  prevailing  in  the  case 
of  commercial  banking  is  afforded  by  the  employment  of  the 
loan  upon  securities,  where  the  borrower  when  the  loan  is 
due  is  forced  to  obtain  elsewhere  capital  sufficient  to  carry 
the  securities  in  question,  the  same  ultimately  being  either 
new  saved  capital  or  deposits  on  the  books  of  the  banking 
system,  in  the  first  of  which  cases  obviously  is  the  discrep- 
ancy alone  remedied  between  the  purchasing  media  and 
goods.  The  course  of  prices  may  also  be  influenced  in 
another  manner  in  the  case  of  investment  banking.  Assume 
that  the  original  extension  of  credit  was  not  excessive,  and 
that  some  depositors  later  desire  to  employ  their  deposits ; 
in  other  words,  that  there  is  a  decrease  in  the  volume  of 
savings  held  in  the  investment  banking  system.    In  the  case 

19  It  should  be  observed  that  the  tendency  towards  equilibrium 
between  the  capital  employed  in  each  sphere  noted  in  the  pre- 
ceding section   represents  basically  a   long   run   tendency. 


OPERATION    OF   THE   BANKING    SYSTEM  153 

of  a  direct  loan  to  a  business  enterprise,  there  is  no  liqui- 
dating counter  flow  of  goods,  and  the  present  holders  of  the 
deposit  credits  originally  representing  the  loan  bid  for  the 
available  goods  coming  on  the  market  against  the  other 
depositors  desiring  to  convert  their  deposit  credits  into 
goods.  In  the  case  of  the  loan  on  or  direct  holding  of  securi- 
ties, however,  no  such  effect  is  produced  for  that  part  of  the 
amount  which  is  employed  as  circulating  capital  by  the  enter- 
prise whose  securities  are  represented.  The  amount  of  the 
counter  flow  of  goods  produced  by  the  enterprise  ^oes  to 
swell  its  deposit  account,  providing  an  offset  against  exist- 
ing investments  of  the  banking  system ;  cancellation  is  not 
effected,  but  the  deposit  account  is  increased  to  bring  about 
the  desired  correspondence^0 

In  short,  mis  judgment  by  the  banking  system  carries  in 
its  wake  certain  effects  upon  prices.  Certain  features  of  war 
finance  as  lately  practised  in  the  United  States  show  the 
same  effects  very  clearly  with  regard  to  general  prices, 
although  it  should  not  be  forgotten  that  in  this  case  titere 
is  a  strong  tendency  eitiier  to  disregard  diese  effects  entirely 
on  the  ground  of  expediency,  or  else  to  hold  that  they  con- 
tribute to  a  desirable  result.  The  accommodation  granted 
Government  may  take  the  form  either  of  purchase  of  treas- 
ury certificates  by  the  banking  system,  purchase  of  bonds,  or 
loans  to  individuals  to  enable  purchase  of  bonds.     In  the 

20  This  statement  holds  true  also  for  the  profits  resulting  from 
the  "investment,"  no  matter  which  of  the  three  forms  thereof  be 
employed,  increase  likewise  occurring  in  both  the  volume  of 
goods  and  in  the  deposit  account.  For  the  individual  bank,  in 
the  case  of  loan  upon  or  direct  holding  of  securities,  it  is  obvious 
that  the  matter  of  immediate  concern  will  be  the  course  of  the 
prices  of  such  securities,  the  relation  of  which  to  the  course  of 
commodity  prices  will  be  apparent.  It  will  be  remarked  that  in- 
vestment banking  operations,  through  this  influence  upon  com- 
modity prices,  affect  commercial  banking  operations  as  well. 


154  BANKING   THEORY 

absence  of  a  clear-cut  theory  of  the  spheres  and  relations 
of  commercial  banking  and  investment  banking,  it  may 
appear  that  the  first  and  third  of  these  may  be  undertaken 
by  the  commercial  banking  system,  inasmuch  as  the  obli- 
gations to  the  banking  system  will  run  for  relatively  short 
periods  of  time.  This  holds  true  only  if  the  terms  be  con- 
sidered in  the  structural  sense ;  basically  an  investment  oper- 
ation is  involved.  Not  only  are  such  operations  not  of  com- 
mercial nature,  but  the  certificates  in  fact  may  not  be  floated 
merely  in  anticipation  of  receipts  from  tax  or  bond  issues, 
but  may  be  kept  out  continuously,  while  with  bond  issues 
twice  a  year,  loans  to  bond  purchasers  may  be  of  six  months' 
duration.  The  reputed  liquid  character  of  such  obligations 
in  fact  is  delusive.  In  all  three  cases  it  is  possible  satisfac- 
torily to  extend  such  accommodation  only  to  the  extent 
that  inactive  demand  and  time  deposits  are  available,  includ- 
ing herein  such  funds  as  business  enterprises  had  designed 
tc  employ  as  circulating  capital  in  their  own  operations,  but 
which  they  are  forced  to  relinquish  for  a  greater  or  lesser 
period  of  time.21  It  should  be  noted,  however,  that  the  time 
of  extension  of  accommodation  in  actual  fact  does  not  corre- 
spond with  the  ostensible  time  of  extension,  but  rather 
with  the  time  of  actual  employment  in  purchasing.  The 
price  effects  attendant  upon  the  late  methods  of  war  finance 
are  now  well  understood.  The  underlying  theory  has  been 
carefully  elaborated  in  the  discussion  of  inflation  in  rela- 
tion to  war  finance  which  has  taken  place,  in  particular  in 
connection  with  the  controversy  as  to  the  proper  proportion 
i»f  receipts  from  loans  and  from  taxes,  and  there  is  sub- 
stantial agreement  along  the  lines  just  indicated.22  From  the 
point  of  view  of  Government  expediency,  these  price  effects 

21  To  this  end  credit  may  be  rationed  and  capital  issues  super- 
vised. 

22  Cf.,   e.g.,    Scott,    Bond    Issues    and    the    Money    Market,    in 
Financial  Mobilization  for  War,  Chicago,  1917,  pp.  126-136,  cited 


OPERATION    OF   THE   BANKING    SYSTEM  155 

have  certain  desirable  consequences,  in  that  they  tend  to 
force  restriction  of  purchasing  for  private  needs.23  Turning 
to  the  real  level  of  the  analysis,  they  thus  induce  a  change 
in  the  relative  production  of  various  classes  of  commodities, 
contributing  to  the  diversion  of  part  of  society  to  the  produc- 
tion of  goods  required  by  Government.  New  goods  required 
by  Government  are  produced,  part  of  the  supplies  of  other 
commodities  required  both  for  Government  and  for  private 
use  are  diverted  to  the  former,  and  the  production  of  com- 
modities purely  for  private  use  is  curtailed. 

5.  The  problem  of  estimation  which  confronts  the  bank- 
ing system  in  its  practical  operations  is  complicated  by  the 
dynamic  character  of  modern  industry,  and  the  existence  of 
the  business  cycle,  conditioned  in  large  part  by  events  of  a 
non-banking  nature.  Coincident  with  the  rythmic  rise  and 
fall  of  busines  activity  is  the  movement  of  prices,  both 
general  and  for  special  commodities.  While  the  banking 
system  to  a  considerable  extent  may  influence  the  course  of 
activity  as  indicated  above,  yet  to  a  greater  extent  it  must 
merely  adapt  itself  to  the  course  of  the  cycle ;  it  serves  rather 
as  contributor  thereto  than  controller  thereof.  According 
to  its  skill  or  lack  of  skill  in  judgment,  it  thus  on  the  one 
hand  may  directly  bring  about  a  general  price  revulsion,  may 
hasten  its  advent,  or  may  accelerate  its  course.     Similarly 

in  Hollander,  War  Borrowing,  New  York,  1919,  p.  159.  It  is  a 
mistake,  however,  to  hold  that  "to  the  extent  that  loans  are 
made  ultimately  from  future  savings  there  need  be  no  infla- 
tion," inasmuch  as  price  effects  may  be  induced  prior  to  the  actual 
saving.  Banking  extension  of  accommodation  to  Government 
serves  merely  to  advance  the  date  at  which  control  over  the 
capital  is  given  it,  and  the  capital  must  actually  exist. 

23  The  inverse  relation  should  be  noted  which  obtains  within 
certain  limits  between  the  price  level  and  the  rate  of  interest  at 
which  Government  bonds  are  floated.  Very  roughly,  the  lower 
the  rate  the  greater  the  necessity  for  banking  accommodation 
and  the  higher  the  price  level. 


156 


BANKING   THEORY 


with  the  prices  of  individual  commodities,  which,  as   re- 
marked above,  it  at  once  tends,  however,  to  decrease  rather 
than  first  to  increase,  as  in  the  case  of  general  prices.     In 
both  these  connections,  it  may  operate  in  the  reverse  manner 
as  well,  serving  rather  in  part  to  stem  and  to  direct  the  tide 
of  the  business  cycle.    On  the  other  hand,  more  largely  will 
it  itself  rather   drift   with   the  tide,    and   its   constructive 
activity  be  confined  rather  to  this  process  of  adaptation, 
both  to  the  existing  and  future  situation.    Where  it  fails  in 
its  judgment  in  this  process  it  will  fall  a  victim  to  price  revul- 
sion, whether  general  or  for  special  commodities  only,  just 
as  surely  as  where  it  itself  largely  contributes  to  such  price 
changes.    As  indicated  above,  the  difficulty  in  which  it  finds 
itself  may  arise  in  a  variety  of  ways, — through  "overlend- 
ing"  to  given  types  of  enterprise,  as  well  as  through  general 
overestimation  of  funds  available  and  consequent  general 
overextension,  each  of  which  may  occur  in  either  commer- 
cial or  investment  spheres,  or  in  both  spheres.     Included 
herein  is  overextension  of  accommodation  for  investment 
purposes  by  organizations  which  are  engaged  primarily  in 
commercial  banking,  the  one  use  then  apparently  encroach- 
ing on  funds  destined  for  the  other  purpose.  While  emphasis 
is  customarily  placed  upon  this  danger,  it  represents  rather 
one  of  several  ways  in  which  difficulty  may  arise.    The  im- 
portant fact  is  that  in  neither  case  is  liquidation  possible  on 
the  existing  basis,  the  commodities  represented  by  the  com- 
mercial loan  being  "frozen"  at  the  prices  on  which  the  loan 
was  made  as  effectively  as  if  the  funds  had  been  applied 
in  the  investment  sphere. 

There  is  nothing  whatsoever  in  the  theory  of  commercial 
banking  and  the  theory  of  investment  banking  expounded  in 
the  present  work  which  is  incompatible  with  the  best  exist- 
ing thought  relative  to  the  business  cycle.24    The  theory  of 

24  E.g.,  Mitchell,  Business  Cycles,  Berkeley,  1913. 


OPERATION    OF   THE   BANKING   SYSTEM  157 

commercial  banking  by  no  means  should  remain  in  the  rudi- 
mentary form  developed  by  the  classical  economists,  but 
should  be  adapted  to  conform  with  the  changes  wrought  by 
changed  economic  conditions  upon  the  evolution  of  the  insti- 
tution itself.  A  conspicuous  example  of  such  change  is  the 
growth  in  technologic  processes  and  in  the  complexity  of 
market  organization,  and  the  corresponding  change  in  the 
organization  of  productive  activity.  The  act  and  test  of 
liquidation  upon  which  prior  operations  in  the  intermediate 
stages  are  predicated  are  now  postponed  until  the  final  stage 
in  the  economic  process.  But  this  by  no  means  requires 
total  abandonment  of  the  theory  itself.  Nor  does  the  tech- 
nical method  of  management  of  an  acute  situation  in  the 
business  world,  which  Moulton  instances,  invalidate  our 
theory.25  Granted  that  free  lending  by  banks  may  be  desir- 
able in  times  of  crisis,  this  means  merely  that  at  such  times 
liquidation  is  deferred  in  order  not  to  throw  simultaneously 
upon  the  market  an  excessive  volume  of  commodities,  with 
the  resultant  effects  upon  prices  and  upon  public  confidence. 
A  more  gradual  process  is  adopted,  readjustment  being 
merely  postponed,  but  not  prevented.  The  conception  of 
alchemy  no  longer  survives ;  neither  here  nor  elsewhere  is  it 
possible  to  "make  something  out  of  nothing."  Again,  the 
employment  of  clearing  house  loan  certificates  in  the  past 
in  American  banking  represents  merely  a  device  whereby,  in 
the  absence  of  effective  technical  organization  of  the  bank- 
ing system,  funds  are  obtained  in  time  of  crisis. 

We  see  then  that  in  the  last  analysis  the  degree  of  effect- 
iveness of  operation  of  the  banking  system  is  the  resultant 
of  two  factors ;  the  skill  of  the  bankers,  and  the  technique 
which  has  been  developed.  The  first  involves  discrimination 
on  the  part  both  of  individual  bankers  and  of  those  who 

25  Commercial  Banking  and  Capital  Formation,  IV,  Journal 
of  Political  Economy,  Vol.  XXVI,  1918,  p.  726. 


158  BANKING  THEORY 

operate  the  central  bank.  In  particular  does  this  hold  for 
the  central  bankers  with  respect  to  technical  operations  such 
as  distribution  of  funds  between  different  places  and  lines 
of  enterprise,  the  control  and  leadership  which  is  exercised, 
and  the  foresight  shown.  While  greater  breadth  of  vision 
is  possible  on  the  part  of  the  central  bankers,  the  individual 
bankers,  who  are  far  closer  to  the  business  community,  must 
likewise  do  their  share.  But  neither  group  will  perform  its 
duty  in  fullest  measure  in  the  absence  of  a  highly  developed 
technique.  This  involves  on  the  one  hand  the  mechanism  for 
performing  the  various  technical  operations,  and  obtaining 
both  coordination  and  control  within  the  system.  The  need 
for  skill  on  the  part  of  the  banker  in  employing  the  delicate 
scientific  devices  which  have  been  developed  is  obvious.  On 
the  other  hand,  the  mechanism  must  be  supported  by  a  clear 
understanding  of  the  underlying  theory  with  respect  to  the 
significance  of  the  institution  itself  as  well  as  to  its  oper- 
ating methods.  Only  when  Jhe  banking  community  is  thus 
equipped  will  the  institution  of  banking  function  effectively. 


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